Rolling Recessions Bring Paralysis to Bernanke, King, Trichet

By Rich Miller and Simon Kennedy

Aug. 4 (Bloomberg) -- Recessions are threatening to crash over the world economy in waves, as one country after another turns down a year after the onset of the global credit crisis.

Such rolling recessions pose a quandary for central bankers Ben S. Bernanke, Jean-Claude Trichet and Mervyn King: If the whole world were clearly slumping, they'd be united in cutting interest rates. Instead, with some countries still booming, they can't ignore the inflation threat. Paralyzed between slowing growth and accelerating prices, U.S. and European policy makers this week are set to fall back on keeping rates unchanged.

``We're in a peculiar situation where, a year from now, we're likely to look back and say that monetary policy makers have made a very, very serious error,'' says David Lipton, head of global country-risk management for New York-based Citigroup Inc. ``The problem is, we don't know whether we're going to say they were too loose or too tight.''

A lot's at stake. If central bankers leave rates too low, they risk stoking global inflation that's already projected by the International Monetary Fund to be the fastest in nine years. Keep rates too high and the world could fall into its first recession since 2001-2002.

In the past, when the U.S. economy weakened, the rest of the world usually followed quickly, and inflation eased as demand for oil and other commodities fell. U.S. recessions in 1990-1991 and 2001 brought global growth down by half, sending fuel prices tumbling.

Slowdown Delayed

That didn't happen this time. The world expansion barely slowed last year and oil prices surged, even as the U.S. economy shrank in the fourth quarter. Only now -- two years after the U.S. housing boom went bust -- is the slowdown spreading worldwide and the price of oil showing signs of receding.

The world may avoid a recession, deemed by economists to be global growth of 3 percent or less, and still end up with what Allen Sinai, chief economist at Decision Economics in New York, calls a ``witches' brew'' of ailments: declines in the housing and stock markets, a credit crunch and commodity-driven inflation.

The energy and credit crises may have permanently weakened the global economy by making production and investment costlier. Deutsche Bank AG economists say long-term growth may fall to 4 percent from 5 percent.

`Weaker for Longer'

While the world rebounded from its last slump to record the strongest expansion since the 1970s, Richard Berner, co- head of global economics for Morgan Stanley in New York, says that ``growth will have to stay weaker for longer'' this time if central banks are to curb inflationary pressures. ``Investors should consider these developments as a regime change,'' Berner says.

The U.S. risks a relapse after bouncing up in the second quarter as consumers spent some of their $91 billion in tax rebates. ``I don't see recovery'' on the horizon, says Harvard University's Martin Feldstein, who serves on the National Bureau of Economic Research committee that determines when recessions start and end.

The big concern is that consumers -- whose spending accounts for more than 70 percent of the economy -- will cut back after their splurge. The omens aren't good: Overdue payments at the six largest credit-card lenders rose in June after falling the two previous months.

Division at Fed

Chairman Bernanke and his Fed colleagues are divided over what to do next after cutting rates to 2 percent from 5.25 percent a year ago. Some, including Dallas Fed President Richard Fisher, favor tighter credit now to contain inflation. A majority prefer to wait and see how the economy develops.

Kenneth Rogoff, a Harvard economics professor and former IMF chief economist, says Fed policy makers are ``stuck.'' While they may want to raise rates to 3 percent to head off inflationary pressures, they can't for fear of upsetting still- fragile financial markets. Consequently, they'll hold borrowing costs unchanged for ``an extended period,'' he says.

European Central Bank President Trichet's dilemma is similar. After dodging the U.S. slowdown last year, the 15- nation euro-area economy may have shrunk in the second quarter for the first time since the common currency's introduction in 1999. As in the U.S., housing booms in Spain, Portugal and Ireland are collapsing, while the euro's appreciation is hurting companies that export.

Recession Risk

``The risk of a recession is no longer negligible,'' says Holger Schmieding, chief European economist at Bank of America Corp. in London.

When a worldwide slump last began in 2001, the ECB cut interest rates. Not this time.

With inflation the fastest in more than 16 years, the bank raised rates to a seven-year high of 4.25 percent last month. Officials warn they'll do more if workers win big wage deals. Employees at Deutsche Lufthansa AG, Europe's second-biggest airline, last week ended a strike after winning a 5.1 percent pay increase retroactive to July 1, and an additional 2.3 percent increase next year.

``The ECB is clearly walking a tightrope,'' says Martin van Vliet, an economist at ING Bank in Amsterdam, who predicts the bank will keep its key rate unchanged until 2009. ``It has to balance the lingering risk of a wage-price spiral with prospective disinflationary pressures emanating from the downturn,'' he says.

Sharp Debate

The debate is sharper at Governor King's Bank of England. The U.K. is slipping toward its first recession since 1990 as house prices slide after tripling in the past decade. With inflation almost twice the bank's 2 percent target, King's policy panel split three ways last month; the majority voted to keep rates at 5 percent.

Japan, too, is at risk of a recession. Exports fell in June for the first time since 2003 and unemployment reached 4.1 percent, almost a two-year high. The Bank of Japan has little room to act, with its benchmark interest rate of just 0.5 percent and consumer prices rising at the fastest pace in a decade.

``The fog hanging over Japan's economy will stick around for the time being,'' bank board member Atsushi Mizuno said July 24.

Even Asia's rapidly growing emerging economies are showing signs of slowing. The region's policy makers are at odds over how to react as inflation remains high.

Chinese officials suggest they may seek to bolster their economy after growth slowed in the second quarter by the most since 2005. Others remain intent on curbing inflation. India has raised rates three times since May while suffering the weakest growth in five years. Surging food and energy costs prompted Indonesia, Thailand and the Philippines to tighten credit in July.

``There's a kind of stagflation marching over the world economy,'' Sinai says. ``I hope policy makers are able to figure it out and make the right decisions to fight it.''

To contact the reporters on this story: Rich Miller in Washington at rmiller28@bloomberg.netSimon Kennedy in Paris at skennedy4@bloomberg.net