Byline: John Fender
Monday January 21 saw a dramatic fall in share prices across the globe. It was unexpected and dominated the headlines.
In response, the US central bank unexpectedly cut interest rates by 75 basis points the following morning (and by a further half percentage point this week) and stock markets seem to have recovered and stabilised somewhat since then. But there are, of course, many unanswered questions.
Why did stock markets fall so dramatically that Monday?
What is likely to happen to the global economy in the coming months and years?
And what is going to happen to the United Kingdom economy?
First of all, it might be helpful to look at the background to the current situation.
Underlying everything is the credit crunch, which originated in the problems caused by sub prime mortgages in the US.
These were mortgages granted to borrowers with dubious credit records - not surprisingly, there were many defaults on such mortgages and, with falling house prices, it was impossible for lenders to get their money back in many cases.
A further complication is that many of these mortgages were parcelled up and sold to other lenders, but it was not known exactly what exposure to these loans many financial institutions had.
This caused lending in the interbank market where banks lend to other banks to dry up as financial institutions became wary of lending to each other.
Those financial institutions that were heavily dependent on the interbank market were particularly badly affected. The chief of these in the UK was, of course, Northern Rock, which experienced a run in September, the first bank run in the UK for well over a century.
The credit crunch is continuing and many potential borrowers are finding it harder to borrow whether via credit cards, mortgages or other types of loan.
The credit crunch means lower consumer spending, and will particularly affect the housing market.
A second ingredient in the current situation is a recent rise in inflation around the world.
In particular, the world oil price has risen significantly, as have food and other energy costs.
The past few years have generally been ones of prosperity, high growth and employment around the world which can be expected to put upward pressure on inflation.
The rise in inflation at a time when there are signs of a marked slowdown in economic activity exposes policy makers to a dilemma.
In the face of a fall in demand, the appropriate response is to raise demand - there are a variety of ways in which this can be done.
In the face of a rise in inflation, the appropriate policy response might be to reduce demand, perhaps through raising interest rates.
So it is not clear what policymakers should do in the face of both a fall in demand and a rise in inflation.
Policy-making in such an environment can be very tricky, particularly as interest changes take time to have an effect and the future is difficult to predict, so that if one carries out a mistaken policy, it may take some time before one realises this.
In the United Kingdom the Bank of England has a target inflation rate of two per cent.
The most recent inflation rate was 2.1 per cent, only marginally above the target. However, there are signs that inflation may rise in the next few months.
If it rises above three per cent, the Governor of the Bank of England has to write an explanatory open letter to the Chancellor of the Exchequer, and Mervyn King, the Governor, warned in a recent speech that he might have to write more than one such letter in the near future. The scope for the Bank of England to follow suit and cut interest rates in the near future to the extent that the Federal Reserve has is, hence, quite restricted.
The Bank of England has already …