Last Thursday America's Federal Reserve announced that it was maintaining interest rates at their historic low levels. On the face of it the decision seems puzzling.
The Fed had been hinting for several months that US interest rates were likely to rise this year. The US economy rebounded strongly in the second quarter and economists have been raising their forecast for US growth this year and next. The Fed's 17th September meeting has looked, for some time, like the most probable date for America's first rate hike in 9 years.
That rates stayed on hold indicates growing concern among policymakers about the effects on America's recovery of the slowdown in emerging economies, especially China, and recent equity market weakness.
Rather than taking comfort from the fact that the Fed did not raise rates, markets took the decision as official confirmation that US growth is vulnerable to China's slowdown. Equities sold off after the announcement, with the UK FTSE 100 dropping 1.4% and the US Dow down 1.7% on Friday trading.
The Fed is right to be hesitant about raising interest rates. Having taken great pains to nurture a recovery, policymakers are wary of jeopardising it with premature interest rate rises. The Fed needs to be confident that the first rate rise will be the first of many. Above all, it wants to avoid damage to the economy, and to its reputation, by raising and then having to cut interest rates.
Others have got this decision wrong. A number of central banks in the rich world, including in Sweden, Canada, Australia and the euro area, raised interest rates after the financial crisis only to have to cut them as the global recovery lost steam in 2011-12.
Low inflation provides another reason for the Fed's caution about raising interest rates. US prices rose by just 0.2% on a year ago, with big falls in the price of energy and food helping drag the inflation rate down. The same story holds in the UK and the euro area, with inflation running at 0.0% and 0.1% respectively. With inflation out for the count central banks can afford to take their time before raising rates.
Indeed, last Friday the Bank of England's Chief Economist, Andy Haldane, said that the case for lowering interest rates is as strong as that for raising them in the UK.
The drop in inflation rates seen in the US and Europe does not look like the toxic deflation that destroys growth and confidence.
So far there is little evidence that low inflation is feeding back into low wages. Indeed, in the UK wage growth has accelerated in tandem with a precipitous decline in inflation. Nor are markets are betting on a long period of deflation; market expectations for inflation in the long term are around 2.0% for most industrialised economies. The euro area, which seemed at the brink of a downward deflationary spiral last year, is out of recession and prices are forecast to rise by 1.2% next year.
Crucially, while low commodity prices are a headache for producing nations like Saudi Arabia, Russia and Brazil, they are a boon for commodity consuming countries. Over the last year falling food, fuel and transport costs have boosted consumer spending power and activity in the West.
Last week's decision to keep rates on hold in the US illustrates a wider dilemma for central banks. The world may have emerged from recession, but inflation is flat on its back and the risks to Western growth from emerging market weakness have risen. Until there is greater confidence that growth can be sustained central banks are likely to keep interest rates at rock bottom levels. It now looks quite possible that US and UK interest rate will stay at current levels until well into 2016.
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