Stephen King: ECB needs to act fast before the problems get worse

The aggressive cuts in US interest rates have worked to boost US competitiveness

Well, it wasn't to be. Hopes that there would be a co-ordinated series of interest rate cuts around the world clearly made no impression whatsoever at either the European Central Bank or the Bank of England. For the Bank of England, the decision to do nothing was understandable: the Halifax bank's alleged house price inflation of more than 30 per cent year on year must be leaving some members of the Monetary Policy Committee feeling slightly queasy. For the European Central Bank, the lack of action is less explicable given the renewed signs of weakness in many parts of the eurozone economy.

Once again, then, the Federal Reserve has been left on its own. The Fed is not a central bank that likes to waste time. Renewed signs of weakness – a "soft spot" within the United States economy, as the Fed chose to put it – provided the justification for a substantial cut of 0.5 per cent in its key Fed funds rate. Even the Fed, however, doesn't want to get too carried away: it indicated that its new policy position was one of "neutrality", seemingly suggesting that there will be no more rate cuts in the remainder of this year.

US short-term interest rates are now extraordinarily low. At just 1.25 per cent, the Fed funds rate is now well below the then daringly low trough – 3 per cent – seen during the credit crunch at the beginning of the Nineties. Interest rates have come down a long way. At the end of 2000, the rate on Fed funds was as high as 6.5 per cent. In total, then, short-term interest rates have fallen by a total of 5.25 per cent, a very sizeable amount of monetary easing by anyone's standards.

By now, you would have thought that the policy should be working. Ask a few American companies, however, and they will tell you a different story. The left-hand chart shows why. On this chart, I have plotted the Fed funds rate, the yield on 10-year Treasuries and the yield on BBB corporate bonds – in other words, the rate that companies have to borrow at on capital markets if they're not in particularly good financial shape, as determined by the credit ratings agencies.

The extent of rate declines has varied significantly. Fed funds has obviously fallen a long way. Recently, there's also been quite a lot of progress on Treasury yields, suggesting that it has become cheaper for the US government to borrow. For BBB-rated companies, however, there has been scant progress. And there are now a lot more of them: many companies that were previously seen to be in good financial shape have had their credit ratings downgraded, leaving them unable to benefit from the lower borrowing costs that the Fed has tried to put in place.

The lack of any substantial decline in borrowing costs for a lot of companies is bad enough, but things get even worse when you take into account the degree to which pricing power has been eroded. In the US, one closely monitored measure of pricing power for companies is producer prices of finished goods, stripping out the volatile food and energy components. At the beginning of 2001, when the Federal Reserve first started to cut interest rates, producers could shove up their prices by 1.9 per cent on an annual basis. By the beginning of this year, producers could manage increases of only 0.3 per cent. By September, producers were having to cut prices by 0.4 per cent on an annual basis.

In other words, although the cost of borrowing has hardly shifted for a lot of companies, the ability to raise prices has been severely curtailed. Put another way, despite the Fed's best efforts to loosen monetary policy, the brutal truth is that, for companies, real interest rates – adjusted for pricing power – have actually risen significantly over the past two years.

There is, however, another source of relief – and some American companies will be welcoming this with desperately open arms. Although the cost of borrowing has not come down, another safety valve has come into play. Dollar depreciation has become a reality over the past 18 months. You might find this difficult to believe, but the facts show that the euro has been in the ascendant since the middle of 2001. Back then, the euro was worth only about 84 cents. Now it's worth more than $1 (see right-hand chart).

In other words, the cuts in US interest rates – which, after all, have been a lot more aggressive than those delivered in the eurozone – have worked to boost US competitiveness. Rate cuts may not have led to a decisive recovery in the stock market and they may not have eased the debt burden for companies, but they have certainly improved the relative price of US goods on global markets.

Is this good news? It depends whom you ask. For US exporters, the fall in the dollar doubtless comes as a welcome relief. However, if the dollar has fallen in value, so have the Chinese renmimbi and a host of other Asian currencies that are linked to the US dollar. In other words, the dollar's weakness is, in truth, more a case of euro strength. On this basis, dollar depreciation is a straightforward "beggar-thy-neighbour" policy, reducing some of the pressures on the US corporate sector by shifting the burden of adjustment onto economies in Europe.

Blaming the Americans for this result is, of course, a little unfair. After all, the rate cuts were not intended solely to deliver a reduction in the value of the dollar: the Fed doubtless hoped to deliver a series of improvements to the fabric of the domestic US economy. The post-bubble hangover has, however, put paid to many of these hopes. It's increasingly looking as though the decline in the dollar is the only direct way in which lower interest rates are beginning to benefit US companies.

The impact on Europe of dollar depreciation should not be taken lightly. The most obvious way in which the eurozone and the UK are affected by dollar depreciation is through a loss in competitiveness. This, however, is not the only effect. European investors who bought US assets with such enthusiasm in the late Nineties are now beginning to discover why Americans were so happy to offload the very same assets. The income generated from these assets is a lot lower than expected, the capital value of the assets has come down a long way in dollar terms and there has been even more destruction in either euro or sterling terms. So Europeans are being punished now for the generosity they showed towards all things American only a few years ago.

This is why the European Central Bank's failure to cut rates is so disturbing. Yes, the ECB has failed to hit its inflation target but, then again, no one else has got a target that is so draconian. The key point, however, is that the ECB seems to be of the view that events in the US have no real impact on events in Europe. That view is wrong. If the only way in which the Fed can stimulate anything like recovery is through dollar depreciation, the ECB had better get rates down fast. Otherwise, Europe will have even more problems than the US in adjusting to a world of lower growth, low inflation and corporate debt that remains at uncomfortably high levels.

Stephen King is managing director of economics at HSBC.