The roller coaster ride in the global financial markets over the past two weeks has hogged the headlines and the attention of the world’s central bankers. The monetary masters of the universe have pumped in billions of dollars to prevent credit markets from having a seizure. There has also been a clamour for interest rate cuts that can bail out investors.
These excitements have ensured that not enough attention is being paid to another problem that central bankers need to address—rising inflation. China’s inflation is already at a 10-year high. Inflation in the US continues to be a worry. The US Fed said last week that rising prices remains its main concern, even as it acknowledged that credit conditions have tightened as a result of the recent market turmoil. In the UK, inflation has been above the Bank of England’s tolerance level, though it has slipped below 2% this week. And it is still premature to proclaim the slaying of the inflation dragon in India.
This poses a dilemma for central bankers, including the Reserve Bank of India (RBI). Moderately high inflation is the most obvious sign that some economies are growing faster than their current capacity, which is pushing up wages, fuel costs and product prices. While it is sometimes argued that inflation is being pushed up because of high prices of oil and food (especially pork, in the case of China), the main problem is that excess liquidity has raised prices of products and assets (including real estate and equities).
It has been argued that the bubble in world credit is the result of a lack of prudence by developing country central banks. They did not rein in money supply growth and credit creation. After all, broad money supply in these countries has increased by an average 21% over the past year, much faster than in the developed countries.
Yet, this is not the complete story. In a world where money flows across national borders in a flash, central banks cannot control the maelstroms they unleash. In India, to give one example, RBI has hiked interest rates seven times in a row and this has helped bring down inflation from its recent highs. Yet, due to strong growth in bank credit and large capital inflows, the fear of inflationary pressures is real. Here the damage has, at least partially, been due to foreign fund inflow.
Central banks have permitted excesses. The US Federal Reserve is the most egregious in this respect. If it has tamed inflation, it has badly faltered elsewhere. Since the mid- 1990s, its interest rate policies have resulted in asset price speculation that powers the intermittent growth spurts in the US. In 2000, it was the stock boom and, since 2003, it has been the housing bubble. The Fed’s cutting of its target rate for an overnight bank rate cutting drive, from 6.5% in 2000 to 1% in 2003, led to the recent liquidity crisis in the first place.
The problem is that even now, in the midst of a liquidity crisis, the lending pattern of the Fed may not squelch such tendencies. In normal times, the Fed accepts collateral of a certain quality. These are mostly US treasury securities. But on 10 August, it accepted mortgage-backed securities of questionable value. Instead of punishing those who indulged in such doubtful lending, the Fed is creating moral hazard and prolonging the problem. What adds to it is the fact that the assets underlying these securities are held in one country, while the securities are owned in another country.
We have to ask what the Fed and the European Central Bank have done to ensure that the recent liquidity injection does not create more problems? In the final analysis, the question these organizations have to ask is whether they should hike interest rates to quell inflation or cut them to stabilize the markets. Who should they think of—ordinary citizens or bond investors?
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