Inflation falling despite rate cuts

ALAN Greenspan's kettle will not boil. Despite the Federal Reserve boss's recordbreaking 11 interest rate cuts, the vital figure for US commercial lending is still falling.

A Fed survey shows that banks are exceptionally reluctant to lend to large and medium-sized businesses and many companies cannot afford the present borrowing rates, which obstinately defy Greenspan's cuts. He is being frustrated by our old friend the yield curve, which measures how interest rates vary according to the length of the loan. Short-term rates, now that the official level is down to 1.75% are, of course, very cheap. But as you go up the curve, rates rise sharply. The 10-year Treasury Bond, which is the benchmark for so much business borrowing, is still being priced by the markets to yield over 5%.

The price of longer-term loans (after the banks have added their costs and allowed for their doubts) is now higher than before the last rate cut, and has scarcely changed since Greenspan started slashing official rates a year ago. The commercial banks' caution is understandable because their customers' profits are low. As a proportion of GDP, they are now 8%. In the halcyon days of the 1960s, they were averaging 14% to 15%.

What dogs the US bond market is a fear that Greenspan's cuts are storing up future inflation. Hence the high yield in the longer bonds. How very different to our own dear yield curve, so slight, so stable. Our 10-year bonds pay almost the same as the two-year variety. The market is confident that the Bank of England will keep inflation under control - no small compliment to the Monetary Policy Committee. Greenspan has few shots left in his locker after the latest cut. Meanwhile, Operation Enduring Bubble continues on Wall Street.

What the Fed wants to avoid at all costs is being caught in a classic liquidity trap, as in Japan, where interest rates have been cut to almost zero. But Japanese people won't borrow and won't spend. Deflation means that goods become progressively cheaper and the dire economic-situation induces consumers to save. Over it all hovers the spectacle of bust commercial banks - bust, that is, if they try to call in their underperforming loans. Many companies cannot pay. And if the banks liquidated their big equity holdings, it would depress the market even more. People are moving their savings out of banks for fear the government will end insurance guarantees of bank customers' cash in April. The banks' managers are also short of creditworthy commercial customers. Japan's bank shares are down over 85% from their 1989 peak with some at danger level.

There are just a few signs of industrial output turning up. But that is probably a bad thing since it may encourage the government to think that further, extreme measures are unnecessary. It may also believe that its extra official spending programme - another one has recently been announced - is restoring economic health.

The Japanese government should nationalise the banks and it should borrow from them (whether owning them or not) and buy official bonds. This would be normally seen as dangerously inflationary, since it would boost the money supply all round. But inflation is what that economy needs to spur spending. The chance of the world's two largest economies being both caught in liquidity traps is a grim thought - all too much like the 1930s. Economists have started to talk of this danger, though only as a modest possibility, not a probability. The Fed is smart and adaptable where the Tokyo authorities are blinkered and obstinate. If nothing else, Japan has provided some useful lessons in how not to tackle recession.