When central bankers got it all wrong

Business Times - 14 Nov 2008

They focused on inflation and raised interest rates despite warning signals and evidence of speculation
By NEIL BEHRMANN LONDON CORRESPONDENT

HISTORIANS will narrate one day how central bankers were hopelessly out of touch with reality ahead of the greatest economic crisis since the 1930s. Despite numerous warnings, notably sliding US and European real estate prices, a worsening credit crisis and tumbling stock markets, most central bankers were mesmerised by inflation until only a few months ago.

They kept interest rates at punitive levels for far too long. The US Federal Reserve Board was slow off the mark, but at least it acted a lot sooner than its European counterparts.

The European Central Bank (ECB) and its governor Jean-Claude Trichet, Bank of England governor Merwyn King and the UK Monetary Committee feared that inflation would accelerate.
With few exceptions, central bankers and most economists didn't appreciate that the inflation, caused by an unusual rise in energy, industrial raw material and food prices, had to be tackled in a different way, rather than by increasing interest rates.

Since the inflation was not the result of a surge in money supply, excess credit or large wage demands or a combination of any of these factors, high interest rates were not the solution. It was ludicrous to keep up interest rates in a world economy that was already beginning to contract because of a growing debt deflation crisis.

The commodity inflation was initially caused by higher demand in the US, Europe, China, India, Latin America and other emerging nations and regions. Soon hedge funds and pension funds caught the ball and prices soared following an extraordinary rise in so-called 'investment', ie speculative flows.

That in turn led to fears of mostly non-existent shortages and panic hoarding. Since global supplies were more than sufficient to satisfy normal consumer demand, the commodity bubble was bound to implode at some point. This in turn would be followed by a swift end to the global raw material and food price rises that had pushed up inflation.

Yet, despite evidence of rampant speculation, central bankers and their advisers chose to ignore warnings of experienced commodity traders.

A collapse in shipping rates on the Baltic Exchange also indicated that global demand for commodities including coal, iron ore and steel was declining. Instead of inflation, the far greater danger was recession.

Only one member of the Bank of England's Monetary Policy Committee, David Blanchflower, stressed that inflation was not a problem and urgently advised from October 2007 that interest rates had to be slashed significantly and quickly. If rates were not cut aggressively the UK faced the prospect of a relatively deep and long-lasting recession, he had stressed.

The European Central Bank, under the stewardship of its inflexible governor and his economic advisers, was even more blinkered in its approach and ignored worsening economic conditions first in Spain and Ireland and then in Italy, Germany, France and other members of the European Union.

Then it happened. Commodity prices collapsed. Crude oil, which was trading around US$30 a barrel in 2004, had soared to US$147 in mid-2008. Now it has fallen back to US$56.

Copper, a good industrial raw material indicator, jumped from around US$1,300 a metric ton in 2004 to a peak of US$8,800 and has since tumbled to around US$3,500. Wheat surged from US$3.50 a bushel around 2004 to almost US$14 in 2008 before plunging to around US$5.30.

Rice, which caused such trauma in Asia earlier in the year and jumped from US$4 to US$25 on the Chicago Exchange, has since declined to US$14. There are numerous other examples of extraordinary commodity price increases followed by steep declines. Since global demand is still weak, prices could fall a lot lower.

People tend to examine recent peaks rather than earlier lows. Most energy analysts used to oil prices of US$20 to US$30 a barrel in 2002 to 2004 neither predicted nor dreamt of quotes above US$50, let alone US$100 within four years of that time.

So what should have the central bankers done? They should have called in the regulators to do something about excess speculation.

The solution is simple and would not have interfered with the free market: Raise the margin deposits on commodity exchanges every day to force speculators to pay up or withdraw.

Simultaneously, central banks should have placed pressure on banks who were lending money to funds that were speculating in commodities on the over the counter market (OTC).

Instead economic gravity has taken hold, pulling prices down. At last, central banks are acting. But had they cut rates earlier, the recession would probably have been shallower with bank bailouts a rarity.