HALF A LOAF

SYNOPSIS: The Central Bank needs to take market psychology into account

It could have been the one-two punch that turned the world economy around. On Monday the Bank of Japan met to set monetary policy in the world's second-largest economy, amid hopes that last year's disastrous decision to raise interest rates would be decisively reversed. Yesterday the Federal Reserve's Open Market Committee met to set interest rates for the world's biggest economy, amid hopes that it would act decisively to stop the slide in America's economic growth.

Alas, both central banks pulled their punches. Not that they refused to act: the Fed cut interest rates half a percentage point, and the Bank of Japan announced what amounted to a humiliating reversal of policy. But in each case the measures taken were half-hearted moves in the right direction, but almost certainly too weak to do the job. And since both central banks faced problems in which market psychology is key, in both cases half a loaf may be as bad as no loaf at all. For if the measures taken in the last two days fail which they almost certainly will the fact that each central bank tried to turn the economy around but failed will damage its credibility, and make it all the harder to engineer a recovery in the future.

Start with Japan. Last year the Bank of Japan somehow managed to convince itself that the right cure for an economy suffering persistent deflation was to raise interest rates. Now it has grudgingly conceded that deflationary monetary policy is, you guessed it, deflationary, and has reversed course. But the bank faces a deep psychological problem. In an economy where prices are falling rather than rising, both consumers and companies are reluctant to spend, since they know that a yen tomorrow is always worth more than a yen today. And this very reluctance to spend feeds the deflation. So what the bank needs to do is convince people that deflation will soon end which means that it needs to act very forcefully.

What the bank did instead, however, was to announce a limited set of measures that are extremely unlikely to turn this psychology around. An uncharitable interpretation of the plan would be that it was designed not to save the economy but to save face to allow the bank to say to its critics, "See, we gave you the expansionary policy you wanted, and it didn't work. So there." And it will be that much harder for any later effort to break the vicious cycle of deflationary psychology.

The situation in the United States is not nearly so grim. We don't have a long history of deflation in consumer prices. But we do have rapidly deflating stock prices, and equally rapidly deflating consumer and business confidence. The Bank of Japan needs to break a vicious circle of self-fulfilling expectations of deflation; the Fed needs to break a vicious circle of self-fulfilling deflation of expectations. This isn't just word play; there is a real similarity in the problems facing the two institutions.

The big difference is that the Fed has a powerful conventional tool at its disposal; since U.S. interest rates remain well above zero, there is still room for substantial cuts.

But yesterday the Fed applied that tool half-heartedly, with a rate cut that almost nobody thinks is large enough to do the trick. The official statement that went with the cut contained the code words "the Federal Reserve will need to monitor developments closely." I take this to mean that the Fed itself suspects strongly that another emergency rate cut will be needed well before the next regular meeting in May. But then why not do it now? Is the Fed, like the Bank of Japan, reluctant to take actions that would amount to an admission of past mistakes?

And while the Fed has room for substantial cuts, it does not have unlimited room which is what makes yesterday's half-measure so disturbing. The point is that every time the Fed cuts rates but doesn't turn things around, its credibility is eroded. Yesterday's market plunge was in effect a vote of no confidence in Alan Greenspan and his colleagues. And that very lack of confidence will now become a drag on economic recovery.

America is not Japan, and the Fed is not the Bank of Japan. But they don't seem quite as different today as they did a few months ago and that is bad news indeed.

Originally published in The New York Times, 3.20.01