Fancy footwork ahead for the Fed

By Gérard Bérubé

The first warning shot was fired on June 30, and economists predict that once the November US presidential elections are over, the road will be clear for the US Federal Reserve to pursue its tight money policy. But the Fed will still have to move carefully, since the current robust economic statistics are based on imbalances that weaken the foundations of the recovery. Such are the constraints of globalization.

The key interest rate was maintained at an historical low for almost two years. This could not last, of course. The hike announced in the US on June 30 was the first in almost four years.

This 25-basis-point increase sounded the death knell for a looser monetary policy and should lead to a hopefully moderate and gradual upward movement once the elections are held. Surely the Fed will have learned a lesson from 1994.

The Fed’s sharp and unex- pected increase of the key interest rate in early 1994 took capital markets by surprise. This reversal suddenly jeopardized the recovering US economy, which had begun to show its first signs of strength since the 1990-’92 recession. The US central bank was forced to quickly backtrack, but the damage had been done.

In this era of globalization, where everything is now intimately linked, the shock wave swiftly spilled over to the emerging economies. The bubble of economic euphoria enjoyed by developing countries in 1992 and 1993 immediately burst, leading to the Mexican peso crisis, the Russian debt problem, and the 1996-1997 Asian monetary crisis that dragged Japan into deflation, making vola- tility the watchword of the 1990s.

Ten years later, the Fed is now facing a similar situation. A parallel could be drawn between the two periods, this time with the back drop of a strong emerging econo-my that could go up in flames.

China, which has maintained an average annual growth rate of 9% since 1994 and where economic hot-beds are now spreading like wildfire, is facing unprecedented pressure. Clearly, it will not be able to maintain control over its monetary lever for long. It is also obvious that its efforts to rebalance, first its interest rates and then its currency, will be sudden and violent rather than gradual, as was the case in 1994.

Today, the synchronization of economic cycles and the high level of correlation generated by globalization require central banks — the US Fed first and foremost — to play the interest rate card another way. They need to redraw the composite sketch of their No. 1 enemy — inflation — and review their targets or inflection points. What makes this even more necessary is the fact that monetary authorities are no longer fighting inflation, but its shadow, i.e., inflationist expectations, with such tight benchmarks that industrialized economies are constantly dodging an even more formidable enemy — deflation.

In 1992-1993, developing economies tried to tell us that globalization brings inescapable realities.

Now even more powerful emerging economies such as those of China and India are repeating the message that we can no longer operate in a vacuum and the butterfly effect is stronger than ever. Old economic reflexes, like the sacrosanct inflation/unemployment trade-off, no longer hold true.

Monetary authorities will have to review their benchmarks, taking into account both the substantial productivity gains now expected from industrialized economies and the global labour market.

The move toward delocalization is changing how labour market pressures are calculated. For example, thanks to its ability to attract the service industries, India has become the world’s back office, and China, nicknamed the workshop of the world, has a pool of 400 million workers eager to earn an hourly rate that is only 3% of the manufacturing wage in the US.

This new reality explains why no jobs have been created in the US in four years, despite the Fed’s unprecedented mon-etary relaxation. Economists estimate it will take the US economy until December or the spring of 2005 at the latest to recover all the jobs lost between the start of the recession in the spring of 2001 and the reversal of the trend in Au-gust-September 2003.

All this should motivate the monetary authorities, who now have their fingers on the trigger, to exercise more restraint and review the models that determine their actions.

Gérard Bérubé is editor of the Économie et finance section of Le Devoir in Montreal