It's not the jolly season for central bankers

ANALYST'S VIEW

Good cheer and glad tidings are in short supply in the corridors of the world's central banks. Policy makers in the industrialized world face the growing prospect of slower growth and higher inflation, at least higher reported inflation from the acceleration in energy and food prices.

Inflation is a lagging indicator. Credit events are deflationary. The constriction of the credit channel will eventually lead to lower inflation. In the meantime, central banks can look forward to a holiday season of bad numbers and rising inflation expectations.

Let's start with that last bastion of monetarism, the European Central Bank. The ECB has become one of the more transparent central banks, something that becomes obvious to anyone visiting its web site. Go to the ECB home page, click on "Monetary Policy,'' then on "Strategy,'' and read about the bank's "two-pillar approach'' to policy. (While you're in the neighbourhood, don't miss the Nifty flow chart on the transmission mechanism of monetary policy.)

Pillar one is economic analysis, which focuses on real activity and financial conditions. Asset prices also get a mention, which separates the ECB from the US Federal Reserve.

Pillar two is monetary analysis, which "exploits the long-run link between money and prices.'' Over time, too much of the first causes a rise in the second. The ECB defines price stability as a year-on-year inflation rate of less than 2 per cent in the medium term.

That nagging equation
So how's the ECB doing, as former New York City Mayor Ed Koch was wont to ask his constituents. Inflation in the 13- member euro zone touched 3.1 per cent in November, the highest in 6 1/2 years. The core measure, which excludes food, alcohol and tobacco, is up 1.9 per cent in the last 12 months. The Europeans don't do much when it comes to inflation.

Real gross domestic product growth in the euro zone has averaged 2.7 per cent in the last two years. Here's where the second pillar comes in.

The ECB doesn't place a priority on the monetary aggregates because another line item looks good on the web site.

There is a long-run link between money and prices expressed as the equation of exchange, or MV=PY, where M is money, V is velocity (the rate at which money turns over), P is prices and Y is output, or GDP. What that means is over time, assuming velocity is constant, nominal growth in the money supply equals nominal GDP.

Money pipeline
Oops. M3, the broad monetary aggregate favoured by the ECB, rose 12.3 per cent in October from a year earlier. There's a big gap "� and a lot of potential inflation "� between real growth of 2.7 per cent and nominal money growth of 12.3 per cent.

No wonder ECB President Jean-Claude Trichet said on December 6 that two options for the ECB were raising rates and holding them steady. The ECB's benchmark rate has been at 4 per cent since June, double what it was two years ago.

Across the pond, the Fed is in an unenviable position as well. It doesn't have two pillars; it doesn't even have a post. What it has is a dual mandate (maximum employment and price stability), an implicit inflation target of 1 per cent to 2 per cent on a price index for consumer purchases excluding food and energy, and some bad inflation news.

The US Labour Department reported on Friday that the CPI rose 4.3 per cent in November from a year earlier and 2.3 per cent excluding food and energy. In a tacit acknowledgment that energy prices have gone one way (up) for seven of the last eight years and food prices haven't fallen on an annual basis in at least 40, the Fed is now releasing quarterly forecasts for overall and core inflation.

Zero Return?
With 10-year Treasury notes yielding 4.23 per cent, less than current inflation, the Fed can take comfort in the fact that investors don't expect today's rate of inflation to persist over the life of the notes.

The bad news is five-year inflation expectations five years from now crept higher last week following a coordinated effort to address banks' short-term funding needs and encourage them to provide loans.

The Fed announced a term auction facility to provide collateralized loans to depository institutions for a month at a rate determined by bid. The ECB, Bank of England, Swiss National Bank and Bank of Canada will offer similar facilities to provide dollar liquidity, pursuant to an increase in their swap lines with the Fed.

Like the ECB, the BOE has an inflation target of 2 per cent. Unlike its European counterpart, it lowered its benchmark rate by 25 basis points to 5.5 per cent on December 6. A week earlier, BOE Governor Mervyn King was fretting over faster inflation.

No Ho-Ho
UK policy makers expect economic growth to slow down as falling home prices and tighter lending conditions conspire to sap what has been a fast-growing UK economy.

Inflation is running at 2.1 per cent. The ten-year inflation expectations have drifted higher over the last couple of years to 3.23 per cent, suggesting that investors don't agree with the BOE's assessment that this month's rate cut "was necessary to meet the 2 per cent target for CPI inflation in the medium term.''

The deterioration in financial market conditions and credit constraints threatening economic growth require the balm of lower interest rates. If central banks can pull it off without igniting inflation or another asset bubble, it's sure to bring tidings of comfort and joy.

(The author is a Bloomberg News columnist)