TOUGH CALLS AFTER BUNJEE-JUMP RECOVERY / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( A MUST READ )

Tough calls after bungee-jump recovery

By George Magnus

Published: August 25 2010 21:41

Financial markets were jolted this week by the 27 per cent fall in existing US home sales in July to levels last seen almost 20 years ago. Although a drop was expected, a more ominous decline in home prices is looming again, along with more pronounced weakness in aggregate final demand. The US may be growing, but by barely more than 1 per cent per annum. With Europe and Japan little better, it now looks as though the bungee-jump economic recovery from last year’s abyss has lost its momentum.

Against this background, the policy debate about how to escape from the debt crisis is about to become increasingly controversial. The US congressional election campaign will focus on whether to allow the Bush tax cuts for upper income earners to lapse, unprecedented UK public spending cuts will be grafted on to the bones of the government’s austerity plan and EU nations with sovereign debt woes are likely to face new turbulence.

It now looks as though monetary policy is going to get a good airing too, starting at this week’s Jackson Hole symposium. Slower growth and tighter fiscal policies should mean sustained easy or even looser monetary policies. The Federal Reserve recently voted to shift the composition of its balance sheet by buying more Treasuries, and the usually hawkish Bundesbank president, Axel Weber, acknowledged the ECB will have to keep open the emergency liquidity pipeline to European banks until 2011. Both institutions, and the Bank of England, are likely to consider more quantitative easing.

But some critics insist monetary largesse is already laying the foundations for accelerating inflation, and that interest rates should be raised with immediate effect. Lone dissenters on the policy-making committees of both the Federal Reserve and the Bank of England are supported by some non-voting monetary policy officials. Their views may find an echo at Jackson Hole, where some policymakers are likely to assert their fears that zero rates and easy money are inviting rising inflation, and new financial instability as unrepentant banks take on too much risk again.

Turning the monetary screw is appropriate in countries that were spared banking, balance sheet and budgetary crises, and that have already acted this year to raise interest rates. But is it appropriate in the US and Europe, gripped by a cycle of deleveraging, balance sheet restructuring and asset shrinkage that makes them especially prone to deflation, not inflation?

Unreconstructed monetarists will not be persuaded, but for the rest of us, the debate should be guided by three principles. First, it is not appropriate to use higher interest rates to address bank behaviour when credit demand and the underlying state of demand in the economy and the labour market are weak. Policymakers should rely instead on regulatory changes – the same kind that they are diluting in the context of Basel III.

Second, the use of higher policy rates to manage asset price inflation is a bona fide discussion, but not for now. Property prices are deflating, equity prices are nowhere close to a bubble and those commodity prices that remain elevated reflect structural conditions not cyclical demand. We may think government bond prices are excessively high, but should not confuse asset allocation preferences with the weak nominal income fundamentals that these high prices reflect.

Third, while there is a lot of money around, for example, banks’ reserves held at the central bank, it is only inflationary if the willingness to spend and borrow is robust. Since it isn’t, and because income and aggregate demand growth are weak, the likelihood of rising general inflation is low. Hoisting short-term interest rates to fight an inflation ghost would be damaging to growth and jobs, especially when governments are determined to pursue fiscal austerity.

Monetary policymakers should draw up plans not to hike policy rates but to define explicitly the circumstances under which they would expand quantitative easing again. Monetary policy is judgment, not science. Better, if necessary, to print money and be damned, rather than tighten policy and be damned. Under the former, there is always redemption by withdrawing the stimulus if circumstances warrant. Under the latter, there is only chaos.

The writer is senior economic adviser, UBS Investment Bank, and author of ‘Uprising: Will Emerging Markets Shape or Shake the World Economy?’

Copyright The Financial Times Limited 2010.