Divided they stand

Published on Saturday 26 January 2008 15:48

Cultural differences mean central banks don't share the same interest in interest, writes Bill Jamieson.

WHATEVER else the world's central banks may be accused of in the most destabilising period for global financial markets since the Second World War, acting in concert is not one of them.

A truly dramatic week, with some of the worst falls seen since the 9/11 terror attacks in America, saw the three most powerful banks in the Western hemisphere respond in three starkly opposing ways. The reaction of the US Federal Reserve was swift and dramatic. That of the Bank of England was more cautious and measured. And the European Central Bank responded to pressure to follow the US with a determined 'Non', or, more accurately, 'Nein'.

Can all three be right? And might this evident lack of co-ordination and joined-up thinking cause the markets to be even more worried than they are?

Government officials and policy advisers at the World Economic Forum at Davos have been unnerved by the absence of a co-ordinated response. Calls for a global approach have now started to come thick and fast. Financial market veterans frequently note that one of the catalysts for the 1987 stock market crash was very public disagreements between the United States and Europe over the appropriate monetary and fiscal policy actions needed. And for them the events of the past week will have been especially scary.

On Tuesday the Federal Reserve, faced with the prospect of a massive collapse in share values on Wall Street, slashed interest rates by 75 basis points. It was the biggest such cut in 23 years and one outside of a scheduled meeting of the Fed's interest rate setting Open Markets Committee.

In voting for such a large cut, the FOMC seemed to imply that the threat to stability was greater than at the time of the 9/11 terror attacks when a 50 basis points inter-meeting rate cut had been deemed sufficient to steady the markets. The FOMC justified its rate action by reference to "a weakening of the economic outlook and increasing downside risks to growth".

But there has been nothing in the data flow to suggest the economic outlook was worsening so rapidly as to call for a rate cut last week rather than wait till this week. And as if this dramatic intervention was not enough, the Fed did nothing to curb speculation that rates would be cut another 50 basis points at its scheduled meeting this week. Indeed, most observers believe US rates will be down to 2.5% by April 30.

In London, the response was altogether more nuanced. On Tuesday evening Bank of England governor Mervyn King doused fevered talk of a copycat rate response when he delivered a sombre speech, warning of economic slowdown ahead but also rising inflation pressures.

King also gave notice that he may need to write an open letter of explanation, "possibly more than one", to the Chancellor – an event triggered when the Consumer Price Index, the official inflation measure – rises above one percentage point above the inflation target to 3% or more. The implicit message from the speech – widely seen as a dark warning of stagflation – was that any further rate cuts in the UK from the current 5.5% level were likely to be measured and more spaced out.

This view was reinforced the following day with news that the Monetary Policy Committee had voted 8-1 against a further rate cut earlier this month. The sole dissenter was arch dove David Blanchflower. This reinforced market views that there would be no bringing forward of the MPC meeting scheduled for February 6 and 7, and that a rate reduction then would be likely to be a modest one of 25 basis points, to 5.25%.

Citigroup expects the MPC to bring rates down to 4.25% by the year-end. "The pace of easing," predicts Michael Saunders, UK economist, "is likely to be constrained by rising near-term inflation and the high level of inflation expectations. On many measures, inflation expectations are the highest since BoE independence. As the January minutes show, the MPC worry that rapid easing could reinforce the impression 'that the Committee was focused more on stabilising demand than meeting the inflation target', and thereby further destabilise inflation expectations. The MPC would prefer to ease too slowly than too fast."

Little such subtlety was evident in the response of the European Central Bank. Every effort was made to douse hopes of an early rate cut. ECB president Jean Claude Trichet re-iterated concerns about Euro zone inflation, currently running at 3.1%, well above the ECB's target of 2%. However, confirmation of slower growth in the weeks ahead is likely to soften the tone, eventually leading to a series of rate cuts totalling 100 basis points by the year-end.

For the moment, however, the ECB is in no mood to encourage speculation of a rate cut. Bank officials went out of their way in the immediate aftermath of the US rate cut on Tuesday to stress that the Euro zone economy is sound and that they would be in no rush to join the US with a stimulus plan to inoculate their economies from the ravages of a stock market plunge.

ECB executive board member Jurgen Stark set the uncompromising tone with a statement that the bank was "very worried and alarmed" about inflation, and that consumer price gains are the ECB's main concern. He said recent developments on stock markets were an over-reaction and their importance should not be exaggerated.

To reinforce the point, ECB vice-president Lucas Papademos said in Luxembourg that "it is more important than ever that central banks continue to pursue policy on price stability."

The ECB has kept its benchmark rate on hold at 4% since June of last year – before August's credit crisis froze bank lending and threatened to stall major economies. Its refusal to cut rates – and encourage reluctant banks to give credit to each other, to companies and to home buyers – could not be in more stark contrast to the thinking and actions of the US Fed, which has now reduced rates four times since last September.

So which response is right – the dramatic slashing of rates by the US Fed, the highly guarded response of the Bank of England governor, or the 'No Surrender' stance of the ECB?

All involve cultural reactions to the crisis at hand, which seems to have acted to bring out fundamental regional differences in philosophy and outlook. US central bank policy, certainly since the mid-1980s under Alan Greenspan, has always seemed especially sensitive to adverse stock market reaction, the memory of 1929-30 being hard-wired into the American financial mind.

The UK has always tended to prefer a pragmatic, muddle through approach. And the ECB's reaction reflects the continuing huge influence of Germany's deep-seated fear of hyper-inflation and its many consequences. The US response, coming as it does on top of a tax cuts package of $150bn and the substantial mortgage re-financing already under way, suggests it may have done too much, just as the ECB reaction suggests complacency about the extent of the slowdown and runs the risk of doing too little. The events of the past few weeks have demonstrated that, when the chips are down, the Fed is much more concerned about growth risks than inflation risks.

Co-ordinated action, neat solution though it seems, may have proved difficult to achieve given the underlying differences over the nature and degree of the threat now being faced.