March 2008

In previous months, we have mentioned the dilemma facing the US Federal Reserve, namely the policy balancing act required to adjust interest rates sufficiently to accommodate economic growth without risking a rise in inflation.

This quandary was highlighted in the minutes of the January meeting of the FOMC (Federal Open Market Committee - the US Federal Reserve’s monetary policy-setting forum). The minutes, published in mid-February, revealed that the FOMC has significantly reduced its 2008 US economic growth forecast to a range of 1.3-2.0%, replacing earlier estimates of 1.8-2.5%.

Most analysts had expected a downward revision to the GDP estimate, but few had anticipated a reduction of this magnitude. As lowering interest rates is a policy tool for stimulating economic activity, the growth adjustment goes some way to explaining the haste with which the Fed cut rates in January (by 1.25% in total) and clearly reflects the central bank’s fears for future growth. Equally of concern, however, was the news that the FOMC has raised its inflation expectations, stoking fears of “stagflation”, a scenario in which growth slows but prices rise.

One of history’s most notable examples of stagflation resulted from the oil crisis of 1973, when Arab producers imposed an embargo of crude supplies to nations who had supported Israel in its war against Syria and Egypt, while oil cartel OPEC simultaneously engineered a sharp rise in world oil prices. For the economies of the US, Western Europe and Japan, the effects of the subsequent leap in the price of oil were crippling and highly inflationary, and continued to have an impact until the early 1980s.

At present, oil is trading around record levels. Although less vulnerable than in the 1970s, the US, as a net oil importer, remains sensitive to a sustained oil price of the current magnitude, and this can only exacerbate the Fed’s predicament of how to ease monetary policy and offset the worst of any credit crisis-induced slowdown without heightening inflationary pressures in the economy.

Some pundits insist that the Fed has reacted too late to avoid at least a domestic recession. Recent economic data releases largely support this view. Matters have not been helped by widening credit spreads in the debt markets and further subprime-induced problems in the banking system. Stabilising the markets requires restoring investor confidence but, given the current growth-inflation constellation, interest rate policy alone may not be enough to achieve this. Without the financial sector’s comprehensive risk disclosure, accompanied by adequate write-offs, restoring confidence will be an uphill task.