The US central bank lowered rates to 3% from 3.5% after a two-day meeting. Last week, the Fed slashed the cost of borrowing by the largest amount in 25 years in a shock move to calm tumbling global stock markets. If you consider the double reduction over 9 days as one event, that’s a 1.25% drop – the largest ever.
The Fed is hoping the cuts will cushion the US economy from the worst effects of the credit crunch and housing slump. But it will not. It may buoy sentiment for a while, but reality will bite again soon. It is necessary that the behaviour of market participants becomes less volatile, and that requires a cultural change , an improvement in fiduciary behaviour and regulatory removal of moral hazard from Wall Street.
(The US economy at a glance.)
Yesterday the US Federal Reserve cut its base rate from 4.5% to 4.25% and the markets slumped. They had expected a bigger cut. While the rate reductions may ease the pain of interest payments, they do not address the fundamental problem of overconsumption fuelled by credit (further analysis here and here). In fact the reductions might exacerbate the moral hazard, encouraging people to spend when they should pay down debt and save.
Unfortunately there is limited moral leadership in America today, except for the likes of Oprah, so the motivation to live within ones means, and those of the environment are limited.
Further easing is likely since this seems to be the main tool available to fix the economy. Unfortunately its not a fix and the problems of credit and exuberant lifestyles will take longer to adjust.
The Bank of Canada cut interest rates for the first time since April 2004, saying that the global economic outlook looked uncertain. It cut rates by a quarter of a percentage point to 4.25% from 4.5%. The central bank said that it expected financial market turmoil, stemming from a collapse of the US sub-prime mortgage market, to persist.
Canada is not going to suffer like the US, but it will be impacted by the US slowdown.
Gisele Bündchen the world’s richest model has given up on the dollar. She now requires that contracts are priced in euros because she does not want to suffer depreciation. Well done Gisele. Now if the oil market can be de-coupled from the US dollar too and central banks diversify their currency holdings, economies around the world would be more insulated from US consumer profligacy and the US government would have to bring more discipline to their economic policy.
And (in an update) it now appears that rapper Jay-Z prefers Euros too. In his new video Blue Magic he is seen cruising the streets of New York in Bentleys and Rolls Royces (now owned by Germany’s Volkswagen and BMW) with a briefcase of 500 euro notes. (Video clip)
The Fed lowered the federal funds rate by 0.25% to 4.5%, as the markets expected and desired. The vote was not quite unanimous with one governor voting to hold. The discount rate was also reduced by 0.25% to 5%.
The reduction in the fed funds rate was almost required given the anxiety of the market leading up to the decision. If there had not been a reduction, the chance of an emotional rout was high. As we’ve said before, reducing the rate is not going to resolve the credit crunch, but has contributed to moral hazard. While equities will continue to come under pressure, it would be sensible for the Fed to communicate that it is unlikely to reduce the rate further for the time being. A resolution of financial imbalances, driven by sub-prime and leveraged investment (PE), must be allowed to occur without handholding by the Fed. It is not the Fed’s job to intervene and it may regret the recent reductions in 2008 when rate reductions might be appropriate. It will be interesting to see what kind of public statements Bernanke and company make going in to November …
A graph of the Euro/Dollar exchange rate puts us in the picture.
I expect it to continue its trajectory for at least three months.
The Indian rupee has risen to its highest level against the dollar since 1998, touching 39.32 to the dollar. The rupee has risen 12% against the US dollar this year. The Reserve Bank of India has intervened in the market to limit the rupee’s rise, purchasing more than $38 billion this year.
Foreign demand for Indian shares and high levels of foreign investment have helped to propel the currency upwards. The strong rupee has helped to subdue inflation by reducing the cost of imports. The appreciation, however, works against exporters, particularly those competing against China, such as textile traders.
India’s spectacular recent growth and its buoyant economic outlook is attracting investors, with foreigners buying $15.3 billion worth of Indian shares this year. The Sensex breached 18,000 on 9 October. Policymakers are worried about the threat to general financial stability from volatility in capital flows.
Its not just the professionals that have benefited from the yen carry trade. Japanese housewives have been moonlighting as currency speculators too. Unfortunately, in the past couple of months the reality that there is no risk free investment has hit them hard, often wiping out savings in a few weeks because of leveraged/margin positions. This linked article from the NYT tells some of the stories.
Many observers have noted the spike in food commodity prices, underpinned by interest in corn for ethanol in the US. There also appears to be a broader rise in prices of commodities which is bound to push up inflation. Last year the pressure on metal commodities from demand from China was observed. As the chart from Reserve Bank of Australia shows, commodity prices have spiked as prices for metals and food are now rising. Their index is at an all time high and the index chart for the past couple of years is vertiginous.
While central bankers and regulators scramble to be seen to do something about the stagnation of financial markets, I do not think that interest rate reductions are going to help. In fact they may exacerbate problems as they contribute to the moral hazard of investors believing there is no downside and contribute to the difficulty of ascertaining the balance of economic conditions because of unnecessary changes in monetary and fiscal policy.
China’s central bank increased rates for the fifth time this year. The one year lending rate is now 7.29% as authorities attempt to ease inflationary pressure. However, the build-up of reserves continues as those that can borrow US$ at under 5%, like multinationals and foreign investors, do. The discrepancy between interest rates net of currency appreciation, fuels a carry-trade.
Their other tactic has been to ease investment control allowing investment outside China, which offers some pressure relief valve for money to find its way out of China. This is unlikely to be sufficient however to moderate inflation. This is therefore going to add to pressure for teh Yuan to appreciate. While the Chinese authorities may accelerate that appreciation they are very unlikely to pursue destabilising step changes in the currency that American and European authorities have been calling for.