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Deflation risk remains if policy makers fail to respond to changes in monetary policies, notes UBS

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Following recent changes in the monetary policy environment, most notably in the US, central banks have clearly been flooding their banking system with liquidity. However, they have not yet guaranteed that banks are, or will, use their excess reserves to lend aggressively to the private sector, says Paul Donovan, UBS's Deputy Head of Global Economics.

"The reasons differ and vary across countries and across time but they all involve some sort of blockage in the credit transmission process that are not atypical in a post-bubble context. The critical point is that while central banks can and do enjoy the power to print money, it does not always follow that stepping on the monetary base accelerator produces the desired results at once, that is higher nominal GDP growth. Balance sheet repairs or restructuring can interfere with the normal processes of reserve and credit creation," said Donovan.

"In this context, global economic recovery is both understandable and at some risk. Our forecasts are predicated on the continuation of difficult but not insurmountable deflationary headwinds but they also highlight the dangers of widening global imbalances since it is only in the US that our forecasts call for meaningfully higher growth. More balanced and durable growth, and a reversal of deflationary risks might well entail still more monetary and fiscal easing initiatives in the months ahead," adds Donovan.

"Japan demonstrates, and the US and Europe worry that central banks can flood the banking system with liquidity but they cannot guarantee that banks will use excess reserves (for cheap loans) to build loan assets to non-banks," said Donovan.

"One solution would be for government to borrow directly from the commercial banking system, instead of issuing bonds to finance fiscal initiatives. With the proceeds, government can then either spend or buy up bonds in the secondary market and simultaneously do what the central banks can't necessarily do, namely effect a funds transfer directly to the non-bank private sector," notes Donovan.

Singapore, 8 July 2004