World growth is slowing…
The global economy is slowing down. And some countries could have a recession – or two consecutive quarters of negative growth - including the UK. After world growth of 5% on average in the last four years, the fastest sustained period since the early 1970s, the rate of expansion is set to ease to 4% this year and to 3.5% in 2009. This growth slowdown would imply a need to lower nominal interest rates but action like that by the monetary authorities would be wrong, and perhaps be a huge policy mistake. The reason is that real interest rates - nominal interest rates deflated by price inflation - are too low at a global level. What do we mean by this?
…but perversely monetary policy is still too loose at a global and regional level…
When real interest rates are below real long run average growth, the monetary policy stance can be said to be expansionary and contractionary when above real growth. Following on from that, low real interest rates therefore generate upward pressure on inflation, as growth is pushed above its long run average, while high real rates create downward pressure on inflation, as growth is pushed lower. Real interest rates are a good guide therefore to whether monetary policy interest rates are too loose or too tight. We have calculated real interest rates for the global economy, and this shows that they are presently too loose, in fact negative, encouraging upward pressure on price inflation. This needs to be tackled. The question is how?
…this is shown by the fact that price inflation is accelerating and real interest rates are negative…
World inflation is accelerating, driven by higher commodity prices and too strong a rise in global demand, but also by a loose monetary stance. This may seem odd, since the credit crisis implies a squeeze on the availability of money and so in theory a tighter policy stance. But that is true only in some countries and, even there, it is not the whole story. The excesses of the credit boom were caused by a too loose monetary stance and its consequences therefore suggest that a return to those policies is neither possible nor desirable nor in fact sustainable. The sharp rise in global inflation is a sign that inflation problems are not confined to one country or region but are a worldwide phenomena and issue. Ignoring rising global inflation would put at risk the achievement of fast global growth that low inflation has brought about. Chart b shows that it was the fall in global inflation that led to lower nominal interest rates and hence a rise in the pace of real growth and its improved sustainability. This achievement risks being lost if inflation is allowed to rise too rapidly.
…including in the major economies hit by the credit crisis
In many countries, from the US to India and China, inflation is at 15 to 20 year highs or more. And chart a illustrates why this is, in the key economic areas, developing and developed, real interest rates are negative. For inflation to fall, real interest rates need to be positive, as the experience of the high global inflation period shows that low real interest rates generate high price inflation. Chart c shows this point more clearly that, currently, real rates are too low in some of the major economies of the world. The good news is that they are still not as low as the level experienced in the 1980s and early 1990s, but will continue to push inflation higher if not reversed. Expectations, using consensus forecasts, suggest that monetary tightening will occur next year. The problem is that it still leaves real interest rates well below their average since 2000, and worse, the rise in real rates only occurs because of falling price inflation. Forward markets suggest that interest rates are expected to be cut in the UK and eurozone. Only in the US are they raised, and then from a very low, and unsustainable, nominal rate of 2%. This is not the case everywhere, of course, and nominal interest rates are being raised in the large emerging markets, but the key question is whether this is enough at the global level? Hence, the danger is that inflation does not remain low as real interest rates are still low after falling next year so that price inflation then accelerates again in 2010 and beyond as growth recovers. Charts d, e and f illustrate strikingly, just how negative real interest rates are in the US, UK and eurozone and how much they have to rise just to get back to the average since 2000, never mind to a tight stance.
The question is will monetary policy be tightened enough to squeeze inflation for more than just a year?
What needs to be done therefore is for real interest rates to rise. That can be accomplished by a combination of falling inflation and by a rise in nominal interest rates. But for price inflation to fall for a sustained period, nominal interest rates must be raised so that real rates are tightened further. In some parts of the world this is already happening but weak growth and the credit crisis has meant this has been half hearted, especially as slower growth hits employment and the poor hard. However, rising inflation erodes real incomes and leads to a longer period of slow growth than if policy responds aggressively in the near term. This is shown by the historical fact depicted in chart b that continued low inflation generates positive effects that lead to long periods of sustained high real growth. However, there are limits to the rate of economic expansion. Beyond that point, excessive inflation is triggered, and the level of real interest rates suggests that too easy monetary policy has now helped to bring that about.
There are also other ways of toughening the overall policy stance, by allowing exchange rates to appreciate, though this is not a global solution, and by tightening fiscal policy, but at the heart of it must be a sustained rise in real interest rates. Unfortunately, this may mean the unpalatable outcome of higher, not lower, nominal interest rates in a number of major developed economies in the future.