One by one, the props on which financial market participants rely are being kicked from under them. The ratings agencies are utterly discredited; bank chief executives are being forced out; their boards of directors have failed in their duties of oversight; rogue-trader risk is back; bond insurers can no longer be depended on. And now, central banks appear intent on destroying their own credibility.
On January 22 the US Federal Reserve, apparently reacting to the two-day rout in global stock markets, cut interest rates by 75 basis points, its biggest emergency cut since 1982.
It leaves its reputation, if not destroyed, then seriously damaged.
A stock market sell-off has been overdue for months and is an understandable response to the growing signs of impending economic slowdown and falling earnings. The stock markets were not irrationally pricing in catastrophe: they were admitting reality.
Stock markets have been in denial, while the credit markets have sensed at first hand the likely economic and market consequences from tighter lending standards, reduced risk appetite for investment and wholesale de-leveraging by the financial players that had previously inflated asset prices. Stock markets might need to fall further, given the economic uncertainties now that the asset-backed securities market, provider of one-third of all credit to US corporations in 2006, remains shut.
The Fed had already acted early and energetically, cutting rates in 2007 by 100bp in expectation of this coming economic slowdown, even while economic indicators remained robust in the fourth quarter of the year. Appearing to react with such importunate haste to head off a much-needed financial correction, appropriately beginning in the bubble markets of Asia where investors finally recognized the myth of economic decoupling from the US, is to invite ridicule. It doesn’t help that the decline in stock prices in Europe may have been spurred on by Société Générale desperately trying to close out huge exposures put on by a rogue trader.
Bankers and investors even sought to excuse the Fed, speculating that it might be reacting to other risks than those to stock traders’ bonuses, perhaps fearing turmoil following from the collapse of bond insurers, although surely the markets should be able to mobilize capital to meet this if it hits.
Thus a move probably designed to assuage panic spooks investors and leaves them jumping at half-glimpsed threats.
Credibility is, in any case, a fragile thing. Rate cuts are most effective when central banks first cut; they subsequently lose effectiveness through the rate-cutting cycle. This time, the ability of lower policy rates to transmit stimulus to the economy may be even more limited. Banks had grown used to holding loans briefly before securitizing them and shipping them out. That entire model is seriously, perhaps terminally, damaged. Collapsing off-balance-sheet vehicles mean banks are forced to hold assets they didn’t want for much longer than they ever intended. The result is much higher capital requirements, coming at a cost banks will try to shift on to borrowers at a time when they have reduced appetite for new lending anyway. As the banking system reluctantly reverts to a lend-and-hold approach it thought it had abandoned, changing policy rates may turn out to be ineffective.
Meanwhile, real interest rates are already low and the risk of rising inflation remains, with inflation expectations in the US at around 3%. Are investors to conclude, then, that the world’s leading central bank favours the old-fashioned solution for over-leveraged households and financial institutions of inflating debts away? That’s a horrible prospect for savers and investors who initially cheered the rate cut and chased stocks back up.
On the same day the Fed cut, Mervyn King, governor of the Bank of England, delivered a plaintive speech in Bristol, England, admitting the bank’s powerlessness as it is squeezed between an economic slowdown spreading from the US and inflationary forces in rising food and energy prices arising from Asian growth. King stresses the importance of understanding the limits on central bank’s ability to smooth the economy, conceding that even with inflation rising, prevailing interest rates are bearing down on demand and so, presumably, he will cut them.
King’s and the Bank’s credibility is already in tatters after it fumbled a quick and dirty private-sector resolution of the Northern Rock fiasco. One can admire his intellectual honesty in admitting how useless the central bank is. Perhaps he need not have shouted it so loudly.