First published: Financial Times, 03/07/2008
The newest anomaly in financial markets tops all others arising in recent months. Inflation fears are now reflected in expectations that US monetary policy will and should become more restrictive before the year is out. The European Central Bank is about to go down this route and the Bank of England may also want to do so.This new twist in the monetary policy tale has some of the hallmarks of the Bank of Japan’s monetary tightening in 1990 to fight inflation, just as the credit crunch was starting to bite. To understand the economic downturn and the growing risk of policy error, we have to acknowledge the influence of deleveraging.Normal business cycles are self-correcting. Deleveraging cycles are self-reinforcing, because the destruction of debts and assets feed on one another until excess leverage has been eliminated. The current deleveraging is unleashing two major deflationary forces.First, the recapitalisation of banks and the restructuring of their balance sheets. Second, the long overdue correction of household balance sheets, especially in the US and UK and anywhere else where personal debt levels have risen rapidly. If we do not see the full effects of deleveraging immediately in economic data, it is probably because economic decisions made by banks and households take much longer to affect the economy than in the case of businesses, which have to make production and employment…more
