Transatlantic division in monetary policy

Financial Times ^ | October 10, 2005 | The Editors

[RWR8189]

Tough talk on inflation, first by US Federal Reserve officials, then by Jean-Claude Trichet, president of the European Central Bank, has got the markets rattled. Last week all the leading equity indices retreated, with the S&P 500 down 2.7 per cent, the FTSE Eurofirst 300 down 1.8 per cent, the Nikkei off 2.6 per cent and the FTSE 100 off 2.1 per cent.

It looks as if investors are questioning the notion that the US, and to some extent the world economy, has entered a new "Goldilocks" phase with growth neither too hot (risking accelerating inflation) nor too cold (risking recession). This hypothesis grossly underplays the impact of the oil price shock, and the dilemma this creates for ­monetary authorities.

With the notable exception of Japan (which merits separate treatment) oil has pushed inflation above the explicitly or implicitly targeted level in all big economies. Core inflation is better behaved, but not unequivocally so. There is just the faintest sign of inflation expectations starting to wobble.

In this context the cost to central bankers of "buying insurance" against a shortfall in demand is prohibitively high. Given the huge cost of allowing inflation to slip away from its moorings, policy has to be set at a level that in all probability will prove a little too tight and, all other things being equal, result in sub-trend growth.

This logic ought not to be taken too far. Circumstances are not ripe for a wage-price spiral. Labour markets are subdued on both sides of the Atlantic, while strong corporate profits provide a buffer against higher wage bills and production costs. This should allow central bankers to put more weight on oil as a tax on consumer spending.

The basic question is whether headline inflation will revert to core inflation (as it broadly should, providing expectations are unchanged and there are no other shocks) or whether core is infected by headline. This can only be answered on a case-by-case basis.

In the US, high capacity utilisation, above trend growth and a surprisingly resilient labour market after hurricane Katrina do suggest some danger of rising core inflation, though this is reduced by continued strong productivity gains. Rates may have to rise, for a while, above a neutral level.

The eurozone, meanwhile, still has core inflation well below headline and chronically weak labour markets with some productivity growth. A rate rise would be masochistic over-kill, though rate cuts will have to be put off until there is hard evidence of headline inflation dropping away.

The UK decision is the hardest. The economy is near full capacity, and while growth is sub-trend, this may be temporary. Recent productivity data is poor. The balance of argument points towards a rate cut, but only just.

Pity Fed chairman Alan Greenspan: he is preparing to step down just as monetary policy gets interesting again.