Hamish McRae: After beating inflation, central banks must guard against deflation

US interest rates come down but nothing happens. Welcome to the world of global deflation.

That may be a bit too stark. Some forecasters, Goldman Sachs for example, are now forecasting a resumption of growth in the US in the early part of next year. Wall Street seems to believe that, to judge by its recent buoyancy. But the disturbing spectre of Japan looms, where declining interest rates have failed to spur economic growth: the country is now in its third recession during the past 10 years.

Maybe it is this experience of Japan or maybe it is just that the economic impact of the attacks on 11 September are beginning to wear off, but some of the most thoughtful market commentators are beginning to focus on the longer term outlook – what will happen during the next 10 years rather than the next 10 months.

For example, Brian Reading, of Lombard Street Research, is talking about a bungee-jump cycle. Instead of looking like a V or a U, the trend of the world economy will be for a bounce off the bottom followed by recoveries and downswings of gradually decreasing magnitude. That would be dismal, but has been pretty much the experience of Japan through the 1990s – at least until the recent fall where the magnitude has suddenly increased in the wrong direction.

The idea that the recovery will be unusually muted by historical standards has been aired here before. Among the reasons for expecting a sober few years is the disappearance of inflation. This week has seen figures from both Britain and France showing falling prices. In the US price performance has been so weak that some commentators are predicting that the Fed Funds rate, which at 1.75 per cent is at a 40-year low, will fall even further. Thus Dr Neal Soss, of CSFB in New York, now expects two further cuts of 0.25 per cent apiece in January and March. Once you get down to interest rates at 1.25 per cent, money at a wholesale level is as near free as makes no difference.

That, however, is at the wholesale level. Neither ordinary people nor ordinary businesses can borrow at that rate. Banks and other financial institutions still have to make their margin to cover not only their costs but also the risks that the borrower may not repay. So the Fed can cut but the benefit does not pass through to the borrowers. You can see this in the first graph, taken from a new paper by Stephen King of HSBC on the shape of the recovery. It shows how the cuts in rates have not made US banks more willing to lend to large and medium-sized companies, a pattern quite different to that of the early 1990s.

His argument is that although there may be a cyclical recovery next year the longer-term growth outlook is poor both for the US and the rest of the world. "The excesses of the late 1990s," he says, "have created a demand 'black hole' for the first few years of the 21st century. Over this period the biggest threat to price stability may ultimately come from deflation, not inflation."

You can see how deflation has undermined the effect of low interest rates by looking at Japan. The other graph shows how ineffective low rates have been in cranking up the economy there.

If this line of argument is right, as I broadly believe, what are the implications?

A bit depends on whether these cuts in interest rates do succeed in stimulating the US economy next year. If they do, then the Fed will have the opportunity to claw back some ground and stick rates back up a bit in the autumn. But if it does not recover much, or if it starts to recover then flops back, there are really no shots left in the Fed's locker. It would be in much the same position as the Bank of Japan since about 1996.

Were the US the only economy in trouble a devaluation of the dollar would help, just as sterling's escape from the ERM in 1992 enabled Britain to start growing again, and hence work off its excesses of the 1980s. But that option is not available to the US, for the eurozone and of course Japan are heading down too. Everybody cannot devalue against each other. Come to think of it, one further implication would seem to be that sterling may actually get stronger against both the dollar and the euro next year. It would certainly not be a safe assumption to think it might become weaker.

If deflation does take hold there will be a series of other consequences. One will be that central bank mandates will have to be altered to encourage them to combat deflation as well as inflation. That symmetry is required of the Bank of England but not, for example, of the European Central Bank.

Another consequence, noted also by Sushil Wadhwani, of the Bank's monetary policy committee and Andrew Smithers of Smithers & Co, is that central banks will have to pay more attention to asset prices. When the economic history of the 1990s comes to be written it may well be that the crucial error of the Fed will be that it focused too much on current prices (which were pretty flat) and too little on asset prices (which were soaring away). So it was lulled into complacency, failed to put up interest rates in time, and allowed a bubble economy to develop.

But that is stable door stuff. What the US authorities have to do now is to avoid the other mistakes of the Japanese authorities, including making sure that the financial system is not undermined by falling asset prices. Mercifully the US financial system is more robust than the Japanese, but the scale of US corporate debt is alarming and it would be naïve not to expect further sizeable bankruptcies post-Enron.

For the rest of us, well, I suppose the message is that we should be aware that we may be at one of those great historical turning points. After the end of the Napoleonic Wars the 19th century became a century of deflation; the second half of the 20th was one of inflation; and maybe the first half of the 21st it will be back to deflation.

That in itself need not be a catastrophe at all. Economies can grow perfectly well under conditions of stable prices. But the adjustment needs to be managed carefully or it will slip into deflation – and central banks need to be aware that they must swing their guns to fight the new enemy, not the old one.