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Benign volatility masks vulnerability Samuel Brittan Financial Times 02/06/06 World financial markets have recently shown increased volatility. What is less often noticed is that beneath the day-to-day tremors the corrections of the last few weeks have, on the whole, been benign. For example, the shake-out in commodity markets has come after a period of extremely rapid rise which, if continued at its old rate, would have been a warning sign of inflation and brought forward world monetary tightening. Even the gold price, which nearly doubled in the past three years, has now slipped back. The dollar has edged downwards, together with sterling, while the euro has edged upwards. Real long-term interest rates have rebounded from almost unbelievably low levels. And equities have come off their recent and unrealistic highs. None of these changes are sufficient to eliminate international imbalances. Jeane-Philippe Cotis, chief economist of the Organisation for Economic Co-operation and Development, is impressed by the way the world economy has withstood shocks and maintained momentum. Real growth in the OECD area has continued at about 3 per cent for the third successive year and is predicted to do the same in 2007. China has enjoyed double-digit expansion, with India on its tail. After years of deflationary weakness, Japan has started to re-expand with personal consumption and business investment joining exports as the main drivers of growth. In the US, hurricanes and other shocks have not stopped economic activity from bouncing back. Even in continental Europe activity has accelerated. Mr Cotis remarks that ?the likelihood of a broader-based recovery extending to consumer demand, now taking hold in Germany, is at its highest level since the late 1990s?. Of course, there are vulnerabilities. Current-account imbalances are widening. The US current-account deficit is forecast by the OECD to rise next year to more than 7? per cent of gross domestic product. Current account surpluses in China and Japan are each headed for around 5?-6 per cent. Domestically, the main threat to expansion is the risk of a downturn in house prices ? the US, France and Spain are regarded as most at risk. Although the growth in shipments from manufacturing economies such as China has had some disinflationary effect, it may, in the OECD?s view, be outweighed by commodity price increases. The recent agreement that the International Monetary Fund should investigate global imbalances and publish its report has been widely hailed. But I have my doubts. It will be less difficult for the established industrial countries to form a consensus on exchange rate changes than on the domestic measures that need to accompany them. If the dollar were to depreciate further without an increase in the US savings rate, the main effects might be a modest upward nudge to inflation in the US, a downward nudge in the rest of the world but a disappointing effect on the payments imbalances. An increase in the US savings ratio seems more likely to come from a housing market shake-out than from a correction of the budget deficit. Ideally, such an increase should be offset by more expansionary policies in Europe and the developing world. But do not count on it. I am still more worried by half-baked ?solutions? to world imbalances than the imbalances themselves. What I found most interesting in the new OECD Outlook was a chart showing that the relationship between the so-called output gap and national inflation rates has become much weaker. Central banks use this gap as their main tool of analysis to decide whether the underlying inflation rate is rising or falling. One possible explanation mentioned by the OECD authors is that it is the pressure of world demand on capacity that is now more important for determining even national inflation rates. One wonders whether there should be something like a world Monetary Policy Committee. But the thought of the main industrial countries plus China and India agreeing on a path for world demand, let alone implementing it and sharing out responsibility, beggars belief. We may have to be content with muddling through. My own main worry is still on the energy front. Suppose there were to be a sustained period of oil at $100 per barrel. This has been investigated by the Goldman Sachs European Weekly Analyst of April 27. The conclusion is that inflation would be boosted and output depressed, but much depends on why the oil price boost occurs. If it is due to excessive demand by the oil-consuming countries, tightening of monetary policies would then be appropriate for dealing with both the inflation and the output effects. Much more difficult would be a supply shock ? an extreme case being the closure of the Hormuz Strait. There would then be an inflationary effect on prices, but a depressing effect on world activity. Thus we would be back to the dilemma of the 1970s of the main requirements of policy pointing in opposite directions. But I fear that the monetary dilemmas would be the least of the problems in that situation.
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