The US economy grew at a pace of 2.2 percent in the last three months of 2006 — down from previous estimates of 3.5 percent, and far lower than some analysts had predicted. The Federal Reserve Board Chairman Ben Bernanke made statements on the need for the US to tackle its deficit, and urgently, as he was put into an uncomfortable position of trying to soothe frayed market nerves when his predecessor Alan Greenspan mentioned the “R” word — recession. Is the US seeing the calm before the storm, and what is the outlook for inflation and monetary policy of the leading industrialized countries? What are the implications for countries that tie their currency to the dollar, such as Saudi Arabia? Will the US cut its interest rates in the short term, to ward off a recession, and what are the implications to those countries holding large US monetary assets if it does?
After four years of robust growth in the world’s economy, inflation seems to be back on the agenda for central bankers almost everywhere. In Britain, the core inflation rate is now at 2.7 percent — above the 2 percent target level — prompting the Bank of England to take drastic action and lift UK interest rates to 5.25 percent in January 2007 — the highest for five years, and catching many financial analysts by surprise. UK interest rates now match those of the US, while the European Central Bank (ECB) lifted rates to 3.75 percent on March 8 this year, the highest level in five and a half years, and hinted at further rises.
The signs are there for all to see, and the biggest surprise is why some seem to be surprised at the unfolding inflationary trends in some major economies. In the UK the rapid growth and borrowing by the Labor government has helped to save the economy from the sluggish growth and outright recessionary signs experienced by others, but the consequences are now being felt in limited UK spare capacity and rising prices. At current trends, a 6 percent level for UK interest rates by yearend 2007 seems possible. What has happened to monetary policy and why are central bankers getting it so wrong in macro-managing inflation and interest rate policies?
Traditionally central bankers have approached the matter in two ways. One standard approach has been to consider changes in interest rates against measures of the amount of spare capacity in the economy. The second approach to evaluate inflationary tendencies is from analyzing the growth of money supply. Both approaches have their problems — a central bank does not know for certain about the size of supply potential in an economy, while in the second approach, money supply figures can be distorted. In today’s globalized economies, credit card payments and offshore bank accounts, capital flows across borders at faster rates, and it is difficult to assess what changes in money supply really mean in the short term. The old days of central banks controlling events in their own country or region are over, as national economies become globalzied and affected by events far away from home. The solutions before seemed to have been straight forward ones — flooding the financial systems with enough liquidity to cushion potential recessions, and then, when it was safe to do so, move in and drain the excess liquidity through “open-market operations” (buying and selling of government securities) and rate increases. However, such actions to solve one crisis seemed to plant the seeds of the next crises in interlinked financial systems and global rotation of financial asset bubbles. As long as greed and overconfidence exists, and there also exist players who leverage on interest rate differentials and easy spreads, then such bubbles will continue, with markets under-pricing risk and willing to take ever higher levels of leverage in search of extra yields.
And what are the likely next moves of the major central banks? Despite signs of a flagging housing market and consumer confidence, the Federal Reserve of the US believes that inflation risk continues to pose the greater risk to the economy, and while a near term change is unlikely, the next move could be up. The same is probably on the cards for the European Central Bank, with a 4 percent rate by summer likely in the face of some strong wage tightening across Europe and higher oil price assumptions.
The Bank of Japan will probably continue to raise overnight rates as its favored monetary tool, as there is uncertainty over long term inflation trends, while the Swiss National Bank could take interest rates to the 2.50 percent levels based on the Swiss franc’s weakness, leading to import price rises and to Swiss exporting companies beginning to experience inflationary round effects in wage deals.
The implication for Saudi Arabia, and for others in the Gulf Cooperation Council (GCC) who have linked their currencies with the dollar, is that domestic interest rates will rise further, affecting marginal borrowing at these higher rates, just when the national economies are in need of a boost in investment following the sharp falls in local stock markets and a dent in consumer spending.
Coming back to the question posed at the beginning — how will countries holding dollar reserves react to possible interest rate movements, especially if the US moves much faster into a recession, and a cut in dollar rates is pushed through in an attempt to bolster consumer demand? Those holding major dollar assets fall into three broad categories — the energy producers (including Russia), Germany, Japan and China. It is very probable that the energy producers will continue to hold their surpluses in dollars for a while yet, but will become increasingly sensitive to returns. The Germans and Japanese will most probably also remain in the dollar, but their surpluses could come down as they will be more susceptible to an economic slowdown in the world. The Chinese have indicated that it is in their self-interest, for the time being, not to take any action that will damage their position in the US markets, even if they have to see a diminished value of their dollar portfolio.
Over the long term, the Chinese too will want to more actively manage their asset returns, and rebalance assets away from the US so that these reflect the new reality of the world’s economy, rather than the US one. In the short run, we will have to live with market jitters and bouts of “corrections”, but these will not be catastrophic in size, until a way is found to redress the global, and primarily, US imbalances.
(Dr. Mohamed A. Ramady is a visiting associate professor, finance and economics at King Fahd University of Petroleum and Minerals, Dhahran.)