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The World Economy In 1996

CAMBRIDGE: The end of decades of inflation and the onset of major long term fiscal restraints are the most striking features of the world economy today. How central banks respond to this is the key question. If they fail to ease monetary policy, deflation is around the corner. If they act promptly, prosperity can last.

In the US three questions arise: For almost 15 years, inflation has averaged less than 4 percent and much less than that in the past 4 years. So, is inflation dead? There is no consensus, but the group of inflation fear mongers is shrinking. In a setting of moderate world growth and a dollar unlikely to weaken, commodity prices will behave well. Labor markets are cool, or at least, certainly not hot. So where is the risk for the Fed in increasing the money supply? The second issue is the budget. There is a huge amount of confrontation on stage. But, as in all bad operettas, the play is unconvincing. The fact is that major budget cutting will happen over the next decade. That is what voters want, that is the fashion, that is what looming social security deficits require.

The third major US economic issue is the consumer. The US has emerged from an investment-led boom; the next round -- to continue good growth -- requires a sturdy consumer. That is hard when debt levels have increased, jobs are unstable, and the middle class is frightened. This is the setting in which decisive rate cuts by the Fed are essential. Real interest rates today are high, more so if we look at the prospect of fiscal restraint. Short rates must come down a full percentage point in the next year to keep growth at 2.5 to 3 percent. Long rates must stay lown and come down further. Small does of rate cuts are best. To succeed, there is no better time to start than now.