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Comment: Heat is on central banks to stimulate growth

Tardy policy response to the growing crisis contributed to global recession. Now, with the UK lagging behind in recovery the pressure is on to turn cash injections into growth support

The global recession is officially over as the US, the eurozone and Japan
returned to positive growth in recent months. Among the big economies only the
UK and Spain recorded GDP falls in Q3. Central banks now must decide how soon
and at what speed they withdraw the huge stimulus injected into their economies.
Tightening policy too early or too abruptly could trigger a double-dip recession
and no one wants to repeat the mistakes made in the past by Japan. But if policy
stimulus is applied for too long, we might seriously worsen the risks of higher

Inflation Central banks see the fight against inflation as their primary role
and they are instinctively very uncomfortable with prolonged periods of
exceptionally low interest rates and huge injections of money into their
economies. Given the fragility of the recovery, they will maintain the stimulus
for the time being.

In the US, the Federal Reserve has explicitly said that rates will stay
exceptionally low “for an extended period”. But it is clear that policy will be
tightened in 2010. Indeed, ‘commodity economies’ ­ such as Australia and Norway
­ have started raising rates already.

The European Central Bank will likely lead, raising official rates in the
first quarter, but this is likely to prove premature since short-term risks to
inflation are still very low, while risks to growth are still severe. The Fed
and the Bank of England will be right to hold fire on raising rates before the
third quarter of 2010 at the earliest.

Tighter monetary policies and cutting huge budget deficits need not cause a
new recession. But we must expect weaker growth than before the crisis. Surges
in share prices seen since March 2009 reflect unrealistic optimism and a
correction of recent excesses is very likely. But equity markets will still be
able to grow modestly in the medium-term.

The role of the dollar will change as the US adjusts and Asia’s status g
rows. In the short-term, it will remain the main reserve currency, seen as a
safe haven. But it will have to share its pivot position with other currencies.

Fiscal policy back in fashion as recession deepens
Governments are terrified by repeated failures to stop recession. Fiscal policy
– public spending, tax cuts, big borrowing ­- is now seen as the salvation. The
new Keynesianism contains valid elements, but is fundamentally a dangerous

The co-ordinated interest rate cut on 8 October, involving six central banks,
was well executed and well received by the media. But the markets dismissed it.
Recession has deepened in all the major developed economies. China is not in
recession, but its slowdown is much worse than predicted.

Though high, inflation has disappeared as a policy issue. The new concern is
deflation in 2009, due to recession and plunging oil and commodity prices. The
call to further action is irresistible.

Only weeks after the 8 October synchronised cut, the main central banks moved
again, this time separately. The US Federal Reserve cut rates to 1%, matching
the low point seen in 2003-04, and will probably cut again soon to a new low of
0.5%; a move to zero is clearly possible if the recession worsens. The Bank of
England, trying to repent for its earlier excessive hard line, slashed rates
from 4.50% to 3%, much more than anyone predicted. Time will tell whether this
was wise or irresponsible. But further UK cuts are likely in the coming months,
at least to 1.5%, and possibly to 1%.

The UK has taken the lead in promoting internationally agreed Keynesian policies
as the best way of averting a slump. In very dire circumstances, more borrowing
is vital and unavoidable. Reduced tax receipts and higher benefits automaticall
y swell budget deficits. Huge banking bailout packages will further inflate
borrowing. The question is how much additional discretionary borrowing is it
safe and sensible to incur. The option must be kept open, but, to avoid major
setbacks, we must proceed with extreme caution.

Bank losses and rising inflation intensify threat
The current credit crunch is unquestionably more difficult, protracted and
dangerous than other recent financial upheavals. The damaging consequences will
take a long time to sort out. The opaque nature of many debt products has made
it difficult to quantify the true size of the losses and has fostered an
atmosphere of panic and exaggeration.

GDP growth forecasts for 2008 have been cut everywhere as a result of the
debt crisis. The downward revision is biggest in the US. But 2008 forecasts are
also weaker for the eurozone, UK, Japan and China. Outright recession is still
unlikely in most major economies, but threats of a nasty 2008 downturn can no
longer be shrugged off.

The Fed acted early and decisively by cutting its key policy rate in September,
from 5.25% to 4.75%, it cut rates again at end-October to 4.50%. The markets
expect it to cut rates at least once more early in 2008 to 4.25%, even though
further easing entails risks. In Europe the reaction has been slower. Eurozone
interest rates at 4% and UK rates at 5.75% have stayed unchanged since the
crisis started in August. But policy is set to ease.

The Bank of England’s gloomy inflation report has been interpreted as a clear
signal that UK Bank rate will be cut to 5.25% and perhaps 5%, before mid-2008.
But, given the mounting risks posed by the strong euro, we expect two cuts in
eurozone rates, to 3.50%, in the next six months.

However, rising inflation is a serious problem. Surges in oil prices to
levels above US $90/barrel, and sharp increases in food prices to levels more
than 30% above a year ago, pose acute risks: they add to cost pressure, squeeze
profit margins and weaken economic growth. The central banks may not be able to
cut interest rates aggressively, just when cuts are needed most. Continued US
dollar falls, while needed, accentuate pressures and may unleash dangerous
international tensions.

David Kern of Kern Consulting is chief economist at the British
Chambers of Commerce. He was formerly NatWest Group chief

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