Central Banks Need a Crystal Ball to Get the Global Overview; Monetary Policy Targets Are Even Harder to Set in a Fast-Changing World, Says Stewart Fleming

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Byline: STEWART FLEMING

WHAT A SHAME, one of Europe's more senior central bankers remarked recently, that Paul O'Neill, the US Treasury Secretary, has been talking about the importance of a strong dollar. It would be so much better, he went on, if he had come into office proclaiming instead the benefits of a strong American economy. This would have let Washington's politicians permit the gradual dollar devaluation the US needs without loss of face.

Until last week, European policymakers also seemed to have locked themselves into a position of excruciating discomfort. In the past month, it appeared that the European Central Bank had made itself a prisoner of its ambitious 2% target for inflation, unwilling to cut rates with euro-zone inflation running above target even though growth in Euroland could be slipping from 3% last year to 2% this. Then on Thursday the ECB stunned financial markets and cut rates anyway.

In moving when it did, the ECB displayed an unanticipated degree of flexibility. Its president, Wim Duisenberg, justified the shift by pointing out that the central bank changes rates in response to what it forecasts inflation will be in up to two years' time when he expects it to be under control. It is a stance that gives the bank plenty of room for manoeuvre.

What is worrying the ECB president most, however, is the fast-deteriorating outlook for the global economy. The biggest threat is from the US. Most forecasters are expecting US growth to slump from 5% last year to at best 1.5% this. But these forecasts are based on the assumption that the dramatic cut in interest rates of two percentage points that the Fed has delivered so far this year, and the further half-point that is expected tomorrow do produce a rapid upswing in the second half of the year - the so-called V-shaped recovery.

But some of these forecasts are being produced more in hope than expectation. US growth is just as likely, economists say, to be U-shaped (a delayed upturn), L-shaped (a long, very slow recovery) or even W-shaped, a brief upturn followed by another slump.

As Duisenberg said on Thursday: "We are as uncertain about the precise future developments of the US economy, which is of crucial importance to the world, as maybe the US authorities themselves."

Knowing the grimmer outlook is all the more likely if business and consumer confidence is undermined, officials are whistling to keep their courage up, not even publishing scenarios that imply a US recession may be possible lest their fears become self-fulfilling.

The problem central bankers face is that the new integrated global economy is behaving in ways that are more unpredictable than ever. …