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The Global Slowdown and Central Banks’ Responses

After hitting a peak sometime in the middle of 2010, the economic recovery seems to have stalled. This observation seems to be true not only of the U.S. economy, but also of other developed economies and some emerging economies.

Figure 1. Sample Quarterly Growth Rates in Developed and Emerging Economies

Both developed and emerging economies are facing very uncertain times. As a result, consumers and businesses are wary of using their funds and are playing it safe. While consumers avoid expenditures in durables and increase their level of precautionary savings, businesses put investment and expansion plans on hold and choose instead to hold risk-free assets. Uncertainty about future macroeconomic variables is precisely one of the channels Margaret Jacobson and Filippo Occhino identify as contributing to investment's softness in the latest U.S. recovery.

In the developed world, the proximate source of this uncertainty seems to be tied to fiscal issues. In the United States the picture is stark: the fiscal year has just ended, but no formal budget has been approved (last year's budget was not complete until April), the deadline for the super-committee charged with finding $1.5 trillion in debt cuts looms closer, the legal standing of the states' challenges to the healthcare reform legislation is uncertain, and the $450 billion presidential job initiative is still in legislative limbo. On top of all that, there is a presidential election in 13 months. But when it comes to uncertainty, the United States has nothing on the Euro Zone. Across the Atlantic, the status of the whole monetary union is being questioned as its debt crisis continues to unravel.

The source of uncertainty in emerging economies is not fiscal, at least not directly. Instead, many emerging economies are very dependent on exports. China, for example, exports roughly a quarter of its GDP according to official statistics. The dependence on exports means that when the developed world's growth prospects are uncertain, so are those of emerging-market economies. Emerging economies depend on exports because their middle classes are still in the process of developing enough purchasing power to sustain continued domestic demand.

Figure 2. Selected Headline Inflation Rates

Central banks around the world find themselves front and center in one of the largest contractions since the Great Depression. Their part is one that seems increasingly more difficult to play, as measures of headline inflation have not subsided since mid-2010, the time when output growth started to sputter. It should be noted that while the Federal Reserve's explicit dual mandate is unusual as far as central banks go, even central banks that have only a strict inflation target seek to achieve their goal while sacrificing as little output as possible.

Central banks around the world have been reacting to the slowdown. In the United States, the Federal Reserve's stance has been rather accommodative since the start of the recession. The federal funds rate remains as low as it can be, and unorthodox balance sheet approaches have been taken to deal with concerns about output, unemployment, and housing markets. Such moves have continued even in the face of increasing inflation (a core measure of U.S. inflation is currently at 2 percent, below the headline measure, but on its way up).

Meanwhile, in the Euro Zone, the European Central Bank's (ECB) stance has been arguably less accommodative. It tightened twice early this year, reflecting inflation concerns, but the tightening cycle is likely over. The ECB has not tightened further in its last two meetings, and it is reportedly not doing so at its October meeting. The question is, rather, whether it will decrease its policy rate in the face of disappointing growth data and subdued inflation.

Figure 3. Selected Policy Rates

In emerging economies, the picture is slightly different. Some economies, like Brazil, experienced large increases in capital flows during 2009-2010, which, together with increases in commodity and energy prices, added to the inflationary pressures. This resulted in a tightening cycle throughout the emerging-market world. On the year, policy rates are up 125 basis points in Brazil, 50 in Russia, 200 in India, and 75 in China. More recently, though, the Banco Central do Brazil has started cutting its policy rate. Could the trend in emerging markets' monetary policy be shifting?

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