Prior to the start of trading in New York, central bankers around the world cut rates by equivalent amounts in an effort to avert a deflationary spiral and to prevent a run on any one currency. This decision was especially difficult for the Europeans, who have been reluctant to accept the thesis as presented by Paulson and Bernanke. However, healthy declines in global indices pushed their hand. Above, France's Prime Minister Francois Fillon delivers a speech during a special debate on the global financial crisis at the National Assembly in Paris October 8, 2008.Time will tell if the concerted rate cuts have the desired effect. In the short-term, a cut in the Fed Funds rate will reduce the cost of commercial bank's primary input by 25%, which should flow through to their bottom line. However, the Fed has been shoveling low-cost short-term money into the financial system to the tune of nearly $1T since September in an unprecedented effort to keep U.S. banks solvent and liquid. Therefore, it is somewhat doubtful that the rate cut will have as big an impact as it would otherwise.
And, if the U.S. and world economies should finally gain traction, the amount of cash sloshing around in the system could trigger runaway inflation.
At the moment, however, the central bankers seem to fear a deflationary spiral more than an inflationary one. This is an interesting hypothesis, considering that there is ample anecdotal evidence that core inflation, excluding volatile food and energy, is running north of 5%. If inflation rates are running this high (even higher if we count the grocery store and the gas station), interest rates will trend higher regardless of the Fed's efforts to peg rates at a low level. In fact, LIBOR (an index that tracks the rates that banks charge for short-term loans to one another) peaked at 5.39% today, but should ease slightly in light of the concerted rate cuts.
What does this mean? It means that the world economy is locked in a crisis of confidence and that the largest banks are no longer confident that the counter-party to their short-term loan will be around long enough to pay the loan back; they are therefore demanding an insurance premium which is shown by the wide spread between the Fed funds rate and LIBOR. This insurance premium, however, virtually insures that the bank accepting those terms will be at increased risk of failure, so the lending bank basically refuses to lend, regardless of how cheap their access to cash may be.
At the moment, however, the Federal Reserve is actively shooting the U.S. dollar full of holes. It is only by virtue of the global nature of this crisis that the dollar has not collapsed completely. The Japanese yen is now on parity with the U.S. cent, something that happened only once before, in the period between July 1994 and August 1995. This dramatic decline in the value of the U.S. dollar, especially if it continues to worsen as can be reasonably expected, is inflationary and reduces the buying power of those on fixed incomes.
Rather than flooding the financial system with liquidity (which isn't getting down to the inner workings of the credit markets due to the fear of bank failure), why doesn't the Fed start a program of loan guarantees for a rate equal to half of the historical spread between Fed Funds and LIBOR? In other words, banks that subscribe to the program can make interbank loans at a rate close to the historical average and have the assurance of the U.S. Treasury that the loan will be repaid. This program, in my opinion, would be cash-flow positive for the Treasury, and, since it will get to the heart of the credit crisis, will increase bank liquidity and reduce the risk of bank failure.
The Federal Reserve announced a program earlier this week that is similar in some regards to my proposal. Essentially, the Federal Reserve began buying commercial paper on the open market with the hope that they could help the market become "unstuck". However, participants in this market know perfectly well that the Fed is a buyer of last resort who is participating in the auctions out of a sense of necessity, rather than because the Fed believes that commercial paper is a good investment. Therefore, this is yet another liquidity move that fails to get at the heart of the problem, which is the fundamental solvency risk of U.S. institutions.
Christian Antalics
No comments:
Post a Comment