Monetary policy

Pulling in the same direction

The Federal Reserve, ECB and four other central banks cut interest rates

IT IS a sign of extraordinary times that dramatic and unprecedented attempts to address the crisis in financial markets no longer cause much of a surprise. And so it was with the co-ordinated action of America’s Federal Reserve and the European Central Bank (ECB), together with the central banks of Britain, Canada, Switzerland and Sweden. Each cut benchmark interest rates by half a percentage point on Wednesday October 8th. The Bank of Japan did not join in but expressed its support for the move. Separately, China’s central bank shaved its lending rate by 27 basis points (hundredths of a percentage point). It also reduced the required share of reserves that commercial banks must keep on deposit with the central bank by 50 basis points.

Getting the world’s big central banks to act in the same way on the same day was a welcome show of unity given the threat to the global financial system and economy. It also minimised the risk of currency instability: a unilateral rate cut by one central bank could have hurt its currency. It may also have prevented accusations that one country was trying to shift the burden of economic weakness onto others. So some form of choreographed action was widely expected this week. The Fed is not usually slow to cut rates in the face of a crisis but it appeared to be waiting until other central banks were prepared to join in. A rate cut by the Fed alone might not have packed much punch. Cutting rates in concert with others should give a better chance of lifting confidence.

The action is a momentous shift for the ECB. After its scheduled rate-setting meeting on October 2nd, the bank’s chief, Jean-Claude Trichet, had indicated that the ECB was leaning towards a rate cut soon. But before that, and despite increasing evidence that the euro-area economy faced recession, the bank had been worried most about inflation taking off. As recently as July, the ECB raised its key rate from 4% to 4.25% to signal to firms and households that it was serious about capping inflation. Now with euro-area inflation at 3.6%, still well above the bank’s target of “close to, but below” 2%, it has seen fit to relax policy.

David Bowers of Absolute Strategy Research, a consultancy, remarks “perhaps price stability is the gold standard of this crisis”. In the 1930s countries that cut their currency’s link to gold early, such as Britain, suffered less economic damage than those that clung on for longer. So policymakers will have drawn a lesson that there is a high price to pay for too much monetary rectitude, especially when others are more flexible. Better to join in than be left behind.

But the main lesson from the 1930s is that keeping monetary policy too tight when the economy is shrinking and banks are failing will ultimately lead to deflation. It is very doubtful that the ECB or the other European central banks have abandoned price stability as their primary objective. The ECB started cutting interest rates in 2001 when euro-area inflation stood at 3.1%, not far below where it is now. At that time, the bank fretted that the collapse of the tech bubble would take the economy down with it, and push inflation too low for comfort. The Fed was similarly concerned about the risk of deflation. The threat to the economy today seems far greater and, with oil and commodity prices slumping, the odds are that inflation is set to fall further—and quickly—from its recent peak. And the statement accompanying the central banks’ action argues that the joint rate cuts are in keeping with their duty to stabilise inflation, rather than a dereliction of it.

There is little doubt that more interest-rate reductions are on the way. The Fed slashed rates to 1% during the most recent downturn, a recession which turned out to be fairly mild. The prospects for the global economy look far worse than they did then, so rates in America are unlikely to stay at 1.5% for long. The one bright spot for Europeans, whose economies have struggled harder than America’s this year, is that their central banks have scope for far bigger cuts.

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