The global economy is slowing down. And some countries could have a recession – or two consecutive quarters of negative growth – including the UK. After world growth of 5% on average in the last four years, the fastest sustained period since the early 1970s, the
rate of expansion is set to ease to 4% this year and to 3.5% in 2009.
Global ‘real’ interest rates are too low
World growth is slowing…
The global economy is slowing down. And some countries could have a recession – or two consecutive quarters of negative growth – including the UK. After world growth of 5% on average in the last four years, the fastest sustained period since the early 1970s, the rate of expansion is set to ease to 4% this year and to 3.5% in 2009. This growth slowdown would imply a need to lower nominal interest rates but action like
that by the monetary authorities would be wrong, and perhaps be a huge policy mistake. The reason is that real interest rates – nominal interest rates deflated by
price inflation – are too low at a global level. What do we mean by this?
…but perversely monetary policy is still too loose at a global and regional level…
When real interest rates are below real long run average growth, the monetary policy stance can be said to be expansionary and contractionary when above real growth. Following on from that, low real interest rates therefore generate upward pressure on inflation, as growth is pushed above its long run average, while high real rates create downward pressure on inflation, as growth is pushed lower. Real interest rates are a good guide therefore to whether monetary policy interest rates are too loose or too tight. We have calculated real interest rates for the global economy, and this shows that they are presently too loose, in fact negative, encouraging upward pressure on price inflation. This needs to be tackled. The question is how?
…this is shown by the fact that price inflation is accelerating and real interest rates are negative…
World inflation is accelerating, driven by higher commodity prices and too strong a rise in global demand, but also by a loose monetary stance. This may seem odd, since the credit crisis implies a squeeze on the availability of money and so in theory a tighter policy stance. But that is true only in some countries and, even there, it is not the whole story. The excesses of the credit boom were caused by a too loose monetary stance and its consequences therefore suggest that a return to those policies is neither possible nor desirable nor in fact sustainable. The sharp rise in global inflation is a sign that inflation problems are not confined to one country or region but are a worldwide phenomena and issue. Ignoring rising global inflation would put at risk the achievement of fast global growth that low inflation has brought about. Chart b shows that it was the fall in global inflation that led to lower nominal interest rates and hence a rise in the pace of real growth and its improved sustainability. This achievement risks being lost if inflation is allowed to rise too rapidly.
…including in the major economies hit by the credit crisis
In many countries, from the US to India and China, inflation is at 15 to 20 year highs or more. And chart a illustrates why this is, in the key economic areas, developing and developed, real interest rates are negative.