Correction or Crash?
Can the world's central bankers head off fears that the credit crunch will spread to the real economy?
U-turns never do much to inspire confidence and the US Federal Reserve appears to be gearing up to deliver a whopper. A week ago officials claimed it would require a calamity for the Fed to intervene with an emergency interest rate cut. Now the world on Capitol Hill is that finance chiefs are considering just that.
Financial markets love interest-rate cuts and may stage a rally, but fear is best measured by enthusiasm for cash and Treasury bills and, right now, fear is at levels not seen for many years. The specific threat? That the current crisis will become a full-scale crash, spilling over into the real economy and leading, inevitably, to recession.
However, there is little chance of that. In the past 20 years, there have tended to be far more financial panics than economic slumps and there is no inevitable connection between the current mess and an unpleasant consequence for the real economy.
Comparisons with previous routs are coming thick and fast, but this is not a recession-panic as in 1998, when the Long-Term Capital Management crisis coincided with weak economic data. Nor is it a panic caused by serious credit losses, as in the banking crisis of the early Seventies.
Defaults on US sub prime mortgages are miles off a level at which triple-A bonds would suffer losses. The current malaise boils down to a crunch in liquidity – and should be addressed as such. Rather than cut interest rates, and risk re-opening the taps of easy money, the Fed should hone its tools to tackle this threat.
It should be clear by now that this is not a healthy correction, but a virulent infection running though the financial system. And the underlying economic data looks ugly: proliferating profit warnings from retailers are a sign that the US consumer market is in trouble. The Fed needs to make substantial interest rate cuts to stand a chance of avoiding serious recession.
However, the current growth cycle is unlikely to peter out until 2008 or 2009 and is more likely to end with a whimper than a bang. Yet so long as the "unknowns" continue, it’s difficult to rest-easy. The scale of leverage in the credit markets, the extent of problems in the US housing market and the unknown reach of the Yen carry trade, may dwarf even the powers of the central banks.
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