The market expects no change in the current 2.0% Fed funds rate at this afternoon’s FOMC announcement. Looking out over the second half of this year, however, the Fed funds futures market anticipates higher rates.
The December ’08 contract is currently priced with a 50-basis point hike to 2.5% in mind. It’s any one’s guess if that forecast will hold, or if it’s even worthy of pursuit. Meantime, the central bank continues to grapple with the twin risks of inflation and deflation, as Martin Wolf writes in today’s Financial Times: “Two storms are buffeting the world economy: an inflationary commodity-price storm and a deflationary financial one.”
It’s not yet obvious that the Fed and other central banks are up to the job of collectively navigating the complex macroeconomic waters that define and threaten the global economy in 2008 and beyond. But resolving this challenge, or not, will determine much of what unfolds in the years ahead. The central banks, in short, have their work cut out for them. Hanging in the balance: trillions of dollars of investments, the outlook for the global economy and the livelihoods of the planet’s workforce.
Alas, cracking this nut isn’t going to be easy. For one thing, much of the experience in central banking is dealing with inflation fighting alone, occasionally interrupted by an outright bout of deflation, as during the Great Depression in the 1930s and Japan for much of the past 20 years. Battling both at once is a rare event, which is to say that the Fed’s experience in dealing with such a beast is relatively thin.
Experienced or not, that’s the predicament du jour. On the one hand, inflation is bubbling. Although absolute levels of prices generally are rising by historically modest standards, the fact that the trend has been up for some time sends a warning signal that central banks can’t, or at least shouldn’t ignore indefinitely.
But while inflation bubbles, demand destruction appears to be gaining momentum too. The latest examples include yesterday’s news on tumbling home prices and plunging consumer confidence.

The hope remains that the demand destruction will derail any inflationary spiral, leaving the economy in relatively good shape for the next upturn. That, at least, has been the Fed’s strategy: lower interest rates sharply without fear that the cuts will spark lasting inflation, courtesy of the demand destruction.
It’s a nice theory, and it may yet work out. But what if it doesn’t? What if inflation doesn’t recede and demand destruction continues apace? That’s called stagflation, and it’s a central banker’s worst nightmare. And for good reason: there’s precious little track record in the history of monetary policy for overcoming the problem. One exception of a sort was during the Volcker tenure in the early 1980s, when political considerations were cast asunder and an all-out effort to break inflation’s back were embraced directly and forthrightly. Of course, winning the war over inflation came at a temporarily hefty price in terms of demand destruction, a fact that only reminds that central banks aren’t really up to the task of fighting a two-front war.
But ready or not, the twin fronts are here. Further complicating matters is the necessity of fighting the war on a global basis. In a globalized economy, the benefits as well as the challenges are spawned by the U.S., Europe, Asia and Latin America together. As such, the proper policy responses ultimately must come in concert too. Indeed, now that globalization has taken root, the rules can’t be temporarily suspended for central bankers.
That doesn’t mean that all central banks should be doing the same thing at the same time. In fact, one could argue that an enlightened and effective policy of central bank coordination these days demands a mix of policy responses that are at once appropriate for the home country while positively supportive of the best interests for the global economy. So it goes in a world that has multiple currencies, multiple monetary policies, multiple economic trends, and multiple inflation rates.
But while the case for coordinated action is strong, it’s not clear that it’s imminent or that the central banks are up to the multi-dimensional task. This is not the challenge of yore, such as the Plaza Accord of the 1980s, when the objective was simply driving down the dollar vis a vis the Deutsche mark and yen. In many ways, that was a one dimensional task with clear objectives and an obvious path to success. Further complicating the task is the fact that some central banks are intent on pegging, in varying degrees, their currencies to the dollar. As a result, the U.S. is effectively setting monetary policy for some countries, and that policy is still quite dovish in a world that’s calling for more hawks.
In any case, today’s challenge is multi-faceted, with objectives including:
* lower inflation
* enhance growth prospects for the global economy
* reduce the trade imbalances between the U.S. and Asia
* soften the pain from the ongoing corrections in the real estate and financial markets but without promoting too much growth, which could ignite even higher commodity prices, which in turn could elevate inflation
* and all the while keep the dollar–the world’s reserve currency–from crashing
Perhaps success on those fronts is possible only in a world with one global central bank overseeing one global currency. Alas, ours is a world with many central banks, which share conflicting agendas and a range of political pressures that don’t always inspire an intelligent monetary policy. Like it or not, this is the world we live in, and the future begins now.