Central Bankers Confront Decision on Which Risk Scares Them Most
Central bankers from the U.S. to China may have to decide which is their worst nightmare: the Great Inflation of the 1970s or Great Depression of the 1930s.
As stock markets slump worldwide and the global economy sputters, monetary-policy makers are struggling to come up with new strategies to spur growth. The catch is that they risk adding to price pressures if they pump more money into the financial system as inflation climbs.
It’s what “are you most scared of” -- the risk of spiraling prices or a plunging economy, said Vincent Reinhart, who was the Federal Reserve’s chief monetary-policy strategist from 2001 until 2007 and is now a resident scholar at the American Enterprise Institute in Washington.
The answer to that question will help determine which way Fed Chairman Ben S. Bernanke and his peers in Europe and Asia choose to tilt policy in the coming months.
Finance ministers and central bankers from the Group of Seven nations said in a statement today they are committed to “take all necessary measures to support financial stability and growth” after last week’s turbulence in equity markets.
If officials err by easing too much and inflation takes off, bond prices will suffer. The yield on the 10-year Treasury note rose to 10.3 percent at the end of 1979 from 7.9 percent at the start of the 1970s as inflation more than doubled to over 13 percent.
The yield was 2.56 percent as of 11:40 a.m. in Tokyo, little changed even after Standard & Poor’s downgraded its AAA credit rating on the U.S. by one level to AA+. Investors in Treasuries earned 3.12 percent in the three months ending July 31, based on Bank of America Merrill Lynch data.
If central bankers keep policy too tight and their economies relapse into recessions, stock prices will slump as earnings fall. The Dow Jones Industrial Average dropped almost 40 percent in the 1930s during the Depression.
Bernanke and his colleagues on the Federal Open Market Committee meet tomorrow to plot strategy against an economic backdrop that looks a lot like a year ago.
Growth is weak, with expansion at a less than 1 percent annual pace in the first half of the year, its worst performance since 2009. The unemployment rate is back above 9 percent, after dipping below that level in February and March. And the equity market is sagging again, with the S&P 500 Stock Index capping the biggest weekly slump since November 2008 on Aug. 5.
‘Doing Too Little’
“There is a one-in-three chance that we’re going to go into recession,” said Lawrence Summers, former director of President Barack Obama’s National Economic Council who is now a professor at Harvard University in Cambridge, Massachusetts. “Although it’s not clear how much impact the Fed can have, the risks are much more on the side of them doing too little than on the side of them doing too much.”
When confronted with that kind of danger a year ago, Bernanke used his Aug. 27 speech at the Fed’s annual conference in Jackson Hole, Wyoming, to pave the way for a second round of bond purchases by the central bank, known as quantitative easing.
“There is almost no chance that the Fed initiates another round of large-scale asset purchases” this week, Feroli said in an Aug. 5 note to clients.
The FOMC instead may alter the language of the statement it issues after the meeting to signal that it will keep monetary policy easier for longer, he said.
What’s different now is that inflation and inflation expectations are higher than they were a year ago. Consumer prices rose at a year-over-year rate of 3.6 percent in June, more than triple the 1.1 percent pace last August.
Levi Strauss & Co., the closely held maker of blue jeans and Dockers pants based in San Francisco, reported that it increased prices in the first three months of the year as cotton costs soared.
“Inflation complicates Bernanke’s decision-making about launching QE3,” said Brian Bethune, visiting economics professor at Amherst College in Massachusetts. “That’s what’s likely to hold the Fed back for now. That could change later if the economy weakens,” he added. “It’s a very tricky situation for the Fed.”
Bernanke’s quandary is complicated by differences among Fed policy makers over how much leeway they have to aid the economy and how much of a risk they face from faster inflation.
No More ‘Ammunition’
Richard Fisher, president of the Federal Reserve Bank of Dallas, said July 13 that the central bank has exhausted its “ammunition” with which to spur growth. Eight days later, Charles Evans, who heads the Federal Reserve Bank of Chicago, said he’d support another round of bond purchases if “circumstances called for that.”
The Fed is under pressure to do more as fiscal policy tightens. Obama signed a compromise on Aug. 2 that raises the nation’s debt ceiling until 2013 and pledges $2.4 trillion in deficit cuts during the next 10 years.
The agreement, which came after months of wrangling with Congress, wasn’t enough to stop S&P from its downgrade, after warning on July 14 that it would reduce the U.S. rating in the absence of a “credible” plan to lower deficits, even if the nation’s $14.3 trillion debt limit was lifted.
European Central Bank President Jean-Claude Trichet faces problems similar to Bernanke’s: a divided policy-making council at a time of worsening trade-offs between inflation and growth as governments adopt austerity measures.
The ECB decided last week to hold borrowing costs steady after raising its benchmark rate twice to 1.5 percent this year, and said it will lend euro-region banks as much money as they need for six months while the region tries to contain a government-debt crisis that is almost two years old.
The central bank also resumed its purchases of government bonds after Italian and Spanish yields soared to euro-era records. While council members were unanimous in keeping rates on hold, a minority opposed reinstating the bond-buying program after a four-month hiatus, Trichet indicated Aug. 4.
The purchases failed to immediately quell the turmoil in European financial markets, as the ECB limited its buying to the debt of Portugal and Ireland, refusing to take on securities from Italy and Spain. On Aug. 7, the ECB signaled it was ready to start buying the bonds of these two countries.
In a statement issued in Trichet’s name after an emergency Governing Council conference call, the Frankfurt-based ECB welcomed efforts by Italy and Spain to reduce their budget deficits, and said it will “actively implement” its bond- purchase program.
There are signs the debt crisis is starting to weigh on confidence in core countries such as Germany. Investor sentiment in the region’s largest economy dropped to a two-and-a-half-year low last month and business confidence also waned. Siemens AG (SIE), BASF AG and Volkswagen AG (VOW), three of Germany’s biggest companies, all reported earnings last month that missed analyst estimates.
Expansion in the euro region probably slowed in the second quarter from 0.8 percent in the previous three months, Trichet told reporters on Aug. 4. The downside risks to the economic outlook have “intensified,” he added.
The threats to inflation, meanwhile, remain on the upside, he said. At 2.5 percent in July, inflation is above the ECB’s 2 percent ceiling.
China’s Balancing Act
China faces a similar balancing act in its decisions about monetary policy. The economy is slowing, partly because of past increases in interest rates. A purchasing managers’ index compiled by HSBC Holdings Plc and Markit Economics fell in July to the lowest level since March 2009.
“Growth has decelerated in the face of the global soft patch in export demand and the weight of tightening,” said David Cohen, an economist at Action Economics Ltd. in Singapore.
At the same time, inflation remains elevated. Consumer prices in the world’s second-largest economy rose 6.4 percent in July from a year earlier, according to the median forecast in a Bloomberg News survey of 25 economists. That would match June’s increase, the biggest since 2008. Data are due Aug. 9.
While consumer-price gains may have peaked in June and July, inflation isn’t likely to fall “significantly” until the fourth quarter, said Li Wei, a Shanghai-based economist for Standard Chartered Bank. Another of the bank’s analysts, Hong Kong-based Stephen Green, said that policy is likely “on hold” and “Beijing will have some space to loosen a little by the end of the third quarter.”
Recoveries from financial crises like the one the U.S. and the world suffered through in 2008-2009 historically have been slow because it takes time to work off the debts built up during the boom years, said Carmen Reinhart, senior fellow at the Peterson Institute for International Economics in Washington.
“When we have the kind of combination of sub-par growth, stubbornly high unemployment and a big debt overhang, you need low interest rates,” said Reinhart, who co-wrote the book “This Time is Different: Eight Centuries of Financial Folly” with Harvard professor Kenneth Rogoff.
“If I had to err, I would err on the side of ease,” added Reinhart, whose husband, Vincent, worked at the Fed. “The ‘30s was a lot uglier than the ‘70s.”
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