For a complete list of Beginners articles, see the Financial Crisis for Beginners page.
One of our regular readers and commenters (and a quite knowledgeable one at that) suggested that we provide an overview of interest rates and the relationship between the Federal Reserve and mortgage rates. So here goes.
Having woken up to the fact that inflation is not the thing to be worrying about, the UK, Eurozone (European Central Bank), and Switzerland all cut interest rates, the Bank of England by a completely unexpected 1.5 percentage points to 3.0%. Disappointingly, the ECB only cut rates from 3.75% to 3.25% (we earlier recommended an immediate cut to 2.0%), although Jean-Claude Trichet did leave open the possibility of further cuts in the future.
In the US, the low Fed funds rate (currently 1.0%) limits the potential benefit of further rate cuts. Europe still has a ways to go; so far, with the UK and the Eurozone set to contract in 2009, there’s no evidence that they couldn’t go further.
Update: What he said. (He, in this case, being James Surowiecki of The New Yorker.)
Global rate cuts: attacking the symptom?
After yesterday’s move by the Fed into the commercial paper market, today’s big news is a global interest rate cut, including the Fed, the European Central Bank, and the Bank of England, among others. The effect of an interest rate cut should be to reduce borrowing costs across the board, which is a good thing for the real economy. However, the rate cut may not have a direct impact on the crisis at the heart of the financial system, which is that banks are not lending to each other. To put this in perspective, the spread between 3-month inter-bank lending rates and 3-month Treasury bill rates – a measure of how willing banks are to lend money to each other, as opposed to socking it away in risk-free Treasury bills – is running at about 4 percentage points. Ordinarily, it should be about 0.5 percentage points. As a matter of simple arithmetic, a 0.5 percentage point cut in central bank interest rates is small compared to a 3.5 percentage point increase in risk premia. As long as lenders are afraid their borrowers could go bankrupt, lowering the cost the lenders pay for money will only slightly lower the price that they charge for money.
Still, though, today’s move is a valuable signal that the world’s central bankers are on the same page and that they will do whatever they can to fight the crisis. And the good news may have come from the United Kingdom, where the government announced a straight-up bank recapitalization plan, in which 25 billion pounds will be used to buy preferred shares in eight banks, and another 25 billion pounds will be allocated to buy shares in those or other banks. Banks that have more capital are less likely to go bankrupt, making other players more willing to lend to them. As we’ve pointed out before, the Paulson Plan may have the indirect effect of increasing bank capital (because we expect Treasury to overpay for the securities it buys under the plan), but uncertainty over how that will work has diluted its impact on the markets. Explicit bank recapitalization is a more direct way to attack the problem.
I would like to express some sympathy for the current predicament of the European Central Bank (ECB). They will undoubtedly come in for a great deal of criticism in the weeks ahead, particularly following their refusal to move interest rates today – if our Baseline Scenario view continues to hold.
But you have to keep in mind that they, unlike the Fed, have a very explicit mandate focused on just one variable: inflation. It is true that there is some scope for interpretation both broad and narrow. The broad scope exists because, for example, if actual growth slows below what is called “potential growth” (a very elusive number), inflation will decline eventually. So when you think about what inflation should be, you are really thinking about where growth is relative to potential – and this is what interest rates can affect (keep in mind all these effects are lagged, i.e., take between one and two years to work their way through the system). And the narrow scope means there is some choice over exactly what inflation measure you aim for and whether you can look at other things (such as money supply). This quickly slips into monetary theology and I’m not going there, at least today.
In any case, the ECB has a pretty clear mandate and it also has a board on which almost all countries that belong to the eurozone get to vote (there are now slightly more members than seats). The management of the ECB comprises the best minds in the business, with impressive experience in the private sector, academia and central banking.
But the basic point comes down to this. The ECB is in Frankfurt. And the real deal is that it represents all that is great and good about post-1945 German monetary policy, with its emphasis on trampling on inflation at every opportunity. This worked well for Germany for a long time and it might even be a good idea now (although I’m a bit skeptical).
The problem is that it is very unclear that this focus on fighting inflation will be appropriate for all eurozone countries. Spain and Ireland are clearly slowing down. The latest data, put out by the European Commission, points to recession in France and Italy.
But the ECB was given a job to do. They have a clear mandate, and they are not supposed to be flexible (unlike the Fed). And the German authorities are watching. The ECB will cut interest rates only when they see eurozone-wide recession definitely “in the data”. Of course, by then it will be too late. But they are really only doing their job. And there is nothing in their job description about preventing the world from slipping into depression.
China and the U.S. Debt
I’m warming up for a longish Beginners-style article on government debt, which will come out next week or so. In the meantime, the New York Times has an article today about China’s diminishing demand for U.S. dollar-denominated debt. Theoretically this could make it harder for the U.S. to borrow money and thereby push up the interest rates on our debt (now at extremely low levels).
China’s voracious demand for American bonds has helped keep interest rates low for borrowers ranging from the federal government to home buyers. Reduced Chinese enthusiasm for buying American bonds will reduce this dampening effect.
However, the article doesn’t mention one compensating factor. The fall in China’s buildup of its foreign currency reserves is linked to the rise in the U.S. savings rate, which is projected to rise to as much as 6-10% (it was over 10% in the 1980s). Some of that new savings will go to pay down debt, but a lot will go into savings accounts, CDs, money market funds, and mutual funds – which means that depresses interest rates across the board. On the back of the envelope, 6% of personal income is about $600 billion a year in new domestic savings to compensate for reduced overseas investment. Whether this will be enough to compensate entirely I don’t know. But if we were all one global economy in the boom, we’re still one global economy in the bust.
→ 3 Comments
Posted in Commentary
Tagged China, deficit, interest rates