AdSlot 1 (Leaderboard)

Comment: Recession forces rate cuts, but inflation will return

Whatever the long-term effects of the financial crisis, it is clear that
threats to growth have won their year-old tussle with inflation risks. Fears of
financial collapse and concerns over deepening recession have forced governments
and central banks to concentrate on alleviating threats to jobs and output at
the risk of higher future inflation.

As well as undertaking colossal banking sector bailouts, policy makers have
executed major u-turns in their monetary policies. Central banks have been
forced to abandon the careful balancing of risks, which usually guides their
actions. The most dramatic step so far was a coordinated 50 basis point cut in
official interest rates involving six major central banks ­ including the Fed,
the European Central Bank and the Bank of England. Significantly, and unusually,
China also cut its official rate at the same time.

Though it has not formally been part of the co-ordinated action, the
involvement of the Chinese underlines the seriousness of the global risks.

With recessionary pressures worsening, we expect additional interest rate
cuts, as well as more injections of public funds into various banking systems.
The Fed, having just cut its key rate to 1.50%, is likely to move to at least
1.25% in the next one to two months. But, with unemployment rising, Fed rate
cuts to 1% or even lower are a realistic prospect. The ECB has defiantly and
unwisely raised rates in July to 4.25%, and the recent rate cut to 3.75% was an
embarrassing turnaround. But the imminent eurozone recession has forced its
hand, with further ECB rate cuts to 3.25% likely in the next three to four
months. The Bank of England, having cut rates recently to 4.50%, against its
earlier inclination, will also have to ease further, probably to 3.75% in Q1

Inflation is still high, well above official targets in most western economies.
The recent inflationary upsurge, driven by food and energy, is at its peak and
inflation will slow sharply in 2009. But government deficits will inevitably
balloon ­ due to massive bank bailouts and the impact of deepening recessions on
public finances. The resulting large monetary expansion must eventually reignite
inflationary pressures. To alleviate the recession we must accept these
consequences. But inflation is not dead; it will resurface with a vengeance in
the future and we will have to fight it again in less comfortable circumstances.

Related reading