Are the central banks risking global deflation?

THERE has been a great deal of discussion recently in the financial markets about whether global monetary policy is too tight. This has been triggered by a series of different events - the recent decline in commodity and producer prices around the world; the increase in real short-term interest rates, triggered by declining price inflation; fears of outright deflation in Japan and the rest of Asia; and the contractionary impact of rising real exchange rates in the OECD economies. The fear among some analysts is that the global central banks may be inadvertently setting monetary conditions so tight that deflation becomes a genuine possibility.

Up until now, there has been very little evidence that global monetary conditions are too tight. The growth in real broad money in the major economies has been accelerating sharply in recent quarters, and it is now running at almost twice the rate of growth in real GDP. Narrow money aggregates are also showing robust and accelerating growth for the OECD economies. Furthermore, the rapid increases in leading indicators which we are observing in both the US and the EU certainly do not seem to imply that monetary conditions are overly restrictive.

Admittedly, it is true that real short term interest rates have risen quite markedly in the G6 economies in the past year. Nevertheless, the level of real short rates at present (2.5%) is still roughly 0.5% below the average for the previous decade, and the impact of any increases in real short rates has been more than offset by declines in real bond yields over the same period. The real 10 year bond yield in the G6 economies now stands at about 2.7%, which is more than one standard deviation below the 4.0% average which has been observed over the past 10 years.

The key question for the developed economies is whether these accommodative readings for domestic monetary policy will be more than offset by the contractionary impact of appreciating real exchange rates. This question is, of course, best answered by looking at monetary conditions indicators (MCIs), which combine short-term interest rates, bond yields and exchange rates into a single index

Up until now, the indices which have been published based on this methodology have suggested that OECD monetary conditions have not only eased very substantially in the last three years, but have attained levels in absolute terms which are towards the easiest end of their normal cyclical range. These indices have therefore offered no support to those analysts who have argued that global monetary conditions are too tight.

However, these MCIs have until now been based on standard trade weighted exchange rate indices (TWIs), as published for example by the Bank of England and other central banks. These indices have typically excluded emerging market currencies, which is of course potentially very misleading. In order to solve this problem, Stephen Hull of Goldman Sachs has now calculated comprehensive exchange rate indices for all of the major currencies, including all of the relevant emerging market currencies. Because of the recent collapse in Asian currencies, these new indices have appreciated much more than the old ones, and this implies that monetary conditions in the developed economies have tightened much more than was previously believed.

In particular, based on the old or conventional exchange rate indices, the MCI in the United States stands only 0.7% tighter than its 1987-95 average. By contrast, on the new exchange rate index, US monetary conditions are estimated to be 2.5% tighter than average, and - more worryingly - they are now tighter than at any time over the past ten years.

No doubt some analysts will argue that this indicates that monetary conditions in the G3 are unnecessarily tight, and that there should therefore be a bias towards renewed easing by the Federal Reserve and other central banks.

This assessment will be further strengthened by the fact that the Taylor Rule (a mechanistic way of determining the optimal level of short-term interest rates via a relationship with output gaps and inflation) now indicates that monetary policy in the G3 economies is too tight.

As can be seen from the accompanying graph, the recent decline in inflation across the developed world has reduced the optimal level of short rates implied by the Taylor Rule very significantly. Actual short rates are now well above their optimal level in both the US and Japan, while in Europe actual short rates are about optimal.

For the OECD as a whole, the Taylor Rule suggests that the current level of short rates is almost 100 basis points too high, which is an unusually large discrepancy. This will undoubtedly add strength to calls for interest rate cuts in the major nations in the months ahead, especially in the United States. However, there are a series of arguments which point in the other direction, and which the central banks need to take into account. These are the following.

First, the main reason why monetary conditions in the major economies have tightened in the last twelve months stems from the collapse in Asian currencies.

Obviously, to the extent that the shift in MCIs for developed countries is triggered by a change in exchange rates, we would expect this to be offset by an easing in MCIs in the rest of the world (where currencies have depreciated), leaving monetary conditions for the entire globe approximately unchanged.

Second, to the extent that the recent collapse in the real exchange rates of the Asian crisis economies is a temporary event, the accompanying tightening in OECD monetary policy will also be temporary. It may not be appropriate to ease domestic monetary policy in the developed economies in order to offset this temporary factor. This is particularly the case in the United States, where virtually all indicators of domestic demand currently remain strong. As Alan Greenspan recently argued in his Humphrey-Hawkins testimony to Congress, the tightening in real monetary conditions which has occurred in the United States in the past twelve months was "not inadvertent" - i.e. the Fed has intended to put a brake on the economy to offset the strengthening in domestic demand, and does not now sympathise with calls to reverse this intended policy tightening.

Third, although real monetary conditions have tightened in the OECD in the latest 12-month period, the impact of this may have been offset by two countervailing forces - an improvement in the terms of trade for the developed economies as oil prices have declined, and a sharp increase in the value of global stockmarkets, notably in the US and the EU. Goldman Sachs has recently added stockmarket valuations into its MCI calculations, and this eliminates most if not all of the "monetary tightening" which has been triggered by the rising dollar in the last 12 months.

Ultimately, the proof of this particular pudding will be in the eating. For as long as domestic demand indicators in the US and EU remain robust, and leading activity indicators continue to rise, then the central banks will probably resist the temptation to reduce domestic interest rates. And they will be entirely justified in doing so.