Crucial questions for the world's central bank

One of the most remarkable phenomena in the financial markets this year has been the sharp improvement in the markets' assessment of the likely path for global interest rates in 1995. Since the beginning of the year, the expected level of short-term interest rates built into money market contracts for the end of 1995 has dropped by 1.6 per cent in the US, 1.2 per cent in Japan, 1.1 per cent in Germany and 0.8 per cent in the UK. This has underpinned the useful rally in bond markets in the first three months of the year.

After all the turmoil in bond markets in 1994, some decline in yields was perhaps on the cards as the risk premia priced into short-term interest rate contracts last autumn returned to more normal levels. However, there has also been a perception in the markets that the global economic recovery has lost momentum since the middle of 1994, and that the degree of central bank tightening that will be needed to cool inflationary pressure has correspondingly declined.

Very recently, the strength of the yen and the mark has triggered calls for an outright easing of policy in those two countries, partly to "save the dollar" and partly to bolster domestic economic activity. Even the usually austere Bundesbank has encouraged speculation about an imminent easing in German monetary conditions.

But if the central banks as a group do wish to "save the dollar", they can choose to do so either with a bias towards overall monetary ease (Germany and Japan both ease while the US does nothing) or with a bias towards overall tightening (Germany and Japan do nothing while the US tightens). Which should they do?

Unfortunately, the central banks are not sufficiently co-ordinated to think in this way. But let us imagine (perhaps it is a nightmare for some) that the monetary policy of the seven main developed economies (G7) were set by a single central bank looking at global economic conditions. It is interesting to ponder whether that global entity should be raising or lowering short-term interest rates right now.

As in any individual country, the G7 central bank would aim for an inflation objective, and would need to consider whether monetary conditions were tight enough to achieve it over the ensuing 12-24 months. At present, the G7 countries seem mostly to be operating with inflation objectives that are close to 2 per cent per annum, so this would be a reasonable target for the group as a whole.

Consumer price inflation in the G7 is currently running at about 2.3 per cent, which is the lowest rate seen since the late 1950s. Furthermore, the growth rate of broad money in the G7 is only around 2.6 per cent, which is significantly less than the 5 per cent growth rate in nominal GDP, so a monetarist-oriented G7 central bank might conclude that overall monetary conditions were slightly too tight.

Against this, real GDP has recently been growing at about 3.2 per cent, which is more than its trend rate of around 2.7 per cent per annum. The margin of spare capacity in the global economy has therefore been falling, as the first graph shows.

The G7 output gap has dropped to less than 1 per cent, and could disappear by the end of this year.

The absorption of spare capacity has been particularly rapid in the manufacturing sector, which has been the main engine of growth in most economies and which is currently growing at an annual rate of about 6 per cent. The utilisation of factory equipment is at above-average rates in the majority of economies.

And this is just beginning to show up in rising inflation pressure at the early stages of the production process, with producer price inflation starting to tick upwards for the first time in the current upswing.

Admittedly, there is no indication yet of any increase in G7 labour costs, which continue to rise by only 0.9 per cent per annum. But the margin of spare capacity in the labour market - the excess of unemployment over its structural rate - has shrunk almost to zero, indicating that downward pressure on wage costs should soon end.

None of this would add up to a compelling case for an emergency increase in world interest rates, but certainly there would be no case for a cut either.

Probably the balance of policy would be tilted in one direction or the other by the view taken by the G7 central bank of the prospects for world activity in the year ahead. If it took the view that GDP growth will remain at 3 per cent or more this year, the balance would be tilted in favour of a tightening in policy, and vice versa.

Recent G7 activity data have shown an unmistakable slowdown from the very rapid rates of growth recorded in the first part of last year, when GDP increased by 1 per cent per quarter (4 per cent annualised). As the second graph shows, this slowed to just under 3 per cent (annualised) in the fourth quarter, with most of the slowdown from earlier in the year being explained by a smaller contribution from stock-building.

A concern for the G7 central bank would be that final domestic demand - especially consumption - is showing only modest signs of a pick-up in Continental Europe, and no sign at all of recovery in Japan. The main generator of growth is therefore still too heavily localised in the US and other Anglo-Saxon economies, though even in those countries there are some spotty early signals of a decline in the interest rate-sensitive sectors, notably housing and cars. If the Anglo-Saxon economies should peter out before final demand gathers steam in Europe and Japan, the world recovery could falter.

But if the governor of the G7 central bank were truly risk-averse on inflation, policy would be driven more by the incipient inflation pressures in the manufacturing sectors than by the unreliable signs of a slowdown in activity, which are often misleading at this stage of an upswing. As explained here last week, the main driving force for overall growth this year should be a strong surge in European investment, which is likely to grow by 5-10 per cent at least.

The clincher is the behaviour of business survey data. This has slowed a little in the US, but has stayed frighteningly strong in other Anglo- Saxon economies, and is on a clearly recovering path in Europe and Japan. If the global upswing has been importantly punctured, this is being cleverly hidden from the companies that respond to these surveys. So a G7 central bank governor should be tilting policy towards tightness rather than ease.

Now back to reality. If our mythical G7 central bank should be tightening policy, if only slightly, it follows that it would be wrong in the real world to respond to dollar weakness by easing overall monetary conditions. A special dispensation should be given to Japan, which is stuck in such a deep recession that it may need to ease policy anyway for its own special domestic reasons. But any reduction in German interest rates, which the Bundesbank has been hinting might come soon, needs to be offset by a tightening in the US. Otherwise, the plight of the dollar will trigger exactly the wrong move in global monetary policy.