A Dangerous Divergence The world's central banks are worryingly far apart 一 especially when I comes to inflation and currencies. “Some say the world will end in fire. Some say in ice." Robert Frost is rarely quoted when central bankers gather. But wise heads nodded when Ken Rogoff, a Harvard professor and former chief economist of the IMF, recited the poet’s apocalyptic lines at a recent meeting of monetary policymakers. The Federal Reserve, said Mr. Rogoff, thinks the world will end in fire. The European Central Bank (ECB) fears ice. The Fed is scrambling to douse financial crisis and recession. In recent days America's central bank has flooded credit markets with liquidity, creating new lending facilities apace. Other central banks have been doling out liquidity too 一 the Bank of England, the Bank of Japan and the ECB did so this week. Whereas the Fed fears recession and financial collapse, most central banks elsewhere are more worried about inflation. Rates in Britain and Canada have been cut. Japanese rates are unchanged. Most other central banks have either kept rates unchanged or raised them. Indeed, central banks outside America, especially in Europe, worry that the Fed may be inviting a new bubble 一 and that the credibility that central banks painfully built over a quarter of a century is now at risk. The gap between the Fed and the rest is having its plainest effects in the currency markets. The dollar has tumbled: against other leading currencies, the greenback is at its weakest since the era of floating exchange rates began in 1973. The dollar's frailty is making policymakers outside America increasingly nervous. Speculation is rising that central banks may intervene to halt the dollar's slide. Some worry that the Fed's easing will boost global liquidity and inflation. All told, the fear is that America's activism in fighting financial distress will create dangerous instability in the global monetary System. The case for boldness With inflation at 4% in the year to February; and the core rate (excluding food and fuel) at 2.3%, America's real short-term interest rates are now negative. In previous downturns, real rates turned negative only at Or after the end of the recession. In the euro area, inflation is lower, but at 3.3% is the highest for 14 years and well above the ECB's 2% ceiling. The Fed has been bolder than other central banks largely because, America's economy is in trouble. It is almost certainly already in recession. But differences in central banks' official goals also play a role. The Fed is charged with promoting both growth and sable prices. Most other central banks in the rich world and a fair few in emerging economies are supposed to worry only about inflation. Many have explicit inflation targets. The Fed has long argued that central bakers should not try to prick 8sset bubbles but must mop up the mess promptly when they burst. Other central banks see a direct link between loose policy after the internet bubble popped and the housing bubble that preceded today’s bust. The Fed has also set more store than others by monetary policy as an insurance mechanism. Concerns about the risk of deflation led Alan Greenspan, the Fed's chairman until 2006, to cut rates hard in 2001-03 and keep them low. Ben Bernanke, Mr. Greenspan's successor, holds these views even more strongly. As an academic, Mr. Bernanke argued forcefully against targeting asset prices. The result, he said, would be unnecessary volatility. In 2003, as a Fed governor, he was one of the loudest advocates of using low interest rates to insure against the calamity of deflation. The calamity being battled today is financial-market malfunction and the damage it can do to the economy. Mr. Bernanke is an expert on the Great Depression and intellectual pioneer of the “financial accelerator”, through which banking distress worsens economic downturns. Lower interest rates, he argues, are an important weapon in stopping this negative spiral. Once a bubble bursts, this means doing more than implied by standard rules of thumb, such as the Taylor rule, which links appropriate interest rates to the deviations of inflation from its target and output growth from its trend. As Frederic Mishkin, another intellectual heavyweight on the Fed's governing board, puts it: “The monetary policy that is appropriate during an episode of financial market disruption is likely to be quite different than in times of normal market functioning." Though dominant, this view is not held by all America's central bankers. Several presidents of regional Federal Reserve Banks have worried openly about inflation. Tom Hoenig, head of the Kansas City Fed, argued recently that "we are placing 100 much burden on monetary policy in dealing with financial crises." These worries are felt far more keenly outside America. First, they say the weakening economy will reduce inflationary pressure. Second, expectations of inflation remain contained. Third, once the risks of financial catastrophe have passed, rapid easing can be mirrored by equally rapid tightening. Sadly, none of these arguments is clear-cut. Granted, more economic slack ought to reduce inflation. And core consumer prices were flat in February. But commodity prices and the dollar point to price pressures ahead. With global growth still robust, the link between domestic output and domestic inflation may be waning. On expectations, some worrying signs are emerging. Survey-based measures are nudging upwards. Market-based measures, such as the spread between inflation-lin ked and Ordinary Treasury bonds, have risen since the turn of the year. The ten-year expected rate of inflation implied by yields on these tw0 types of bonds has reached 2.5%. An alternative measure from the Cleveland Fed that adjusts for differences in liquidity and the premium for inflation risk in markets for the two has risen even more. Finally, it is hard to be sure that swift cuts will be as swiftly reversed, as Mr. Mishkin and others say. John Taylor, the Stanford economist who invented the Taylor rule, points out that whenever the Fed has cut rates by more than his rule suggests, it has taken a long time to get interest rates back on track. And the danger posed by dysfunctional Credit markets will not disappear overnight. Since rapid tightening may pose renewed financial risks, the Fed's own logic suggests rates will be raised gradually. Knock-on effects For a start, currencies tend to swing around by far more than warranted by differences in 1nterest rates: the euro's recent surge against the dollar is an example. Currency volatility can itself cause panic, especially when the dollar tumbles, given America's reliance on foreign capital. And market movements can send exporters in countries with rising currencies screaming for help. These problems can be particularly acute in small, open economies. More important, not all exchange rates float freely. The Gulf's oil exporters, for instance, tie their currencies to the dollar: the Saudi riyal is fixed firmly at 3.75 to the greenback. Countries with dollar pegs are in effect importing America's looser monetary policy and with it inflationary pressure. Saudi Arabia's inflation rate is at a 27-year high of 7%. There are signs that the Fed's policy is prompting some countries to reconsider their links to the dollar. Many Asian countries have already allowed their currencies to rise substantially China, which abandoned its dollar peg in 2005, has accelerated the pace of the yuan's appreciation. In the short term it will make the dollar more volatile as investors worry that emerging-market central banks will be less keen to hold large amounts of dollars. If American interest rates remain disproportionately low, other emerging markets may resort to controls n capital inflows. Even so, it will be hard for small, open economies to hit their inflation targets if American policy remains so loose. Nor are big economies likely to ignore their currencies. The ECB, for all its bluster, may have to loosen sooner than it would wish to in order to stem the euro's rise. Mr. Taylor' S research suggests that the ECB's deviations from“optimal” policy have been closely correlated with America's short-term interest rates. A percentage- point reduction in the federal funds rate has been associated with a move of a fifth of a point away from the ECB's optimum. Worries about exchange rates, he argues, cause central banks to veer off course. How worrying all this is depends on its scale. Modestly higher inflation or jumpier currencies seem a small price to pay for preventing the collapse of America’s financial system. The darkest scenario 一 that investors panic at the Fed's loose policy, sending the dollar into free-fall- is becoming worryingly plausible. A real dollar Crash would force the Fed to raise rates, making America's predicament much Worse and even sending the global economy into recession.