Mid-Day Reflections on Joint Central Bank Action

October 8, 2008

Investors seem unconvinced that they no longer need to fear the market’s collective fear.  The Dow Jones Industrial Average remains extremely erratic.  It was down more than 200 points at noon EDT (16:00 GMT) but marginally in the black 85 minutes later.  An eventual decline to at least 7,780, which would match the 45% bear market during the Watergate period, seems probable to me, and one should not dismiss a plunge beyond the October 2002 low of 7,197.  Commodity prices are weak, a sign that deflation and not inflation is what central banks should be most worried about.  The 10-year Treasury note yield is 9 basis points higher than Tuesday’s close at 3.65%.  There are conflicting forces to consider on bonds: deflation and safe-haven inflows on the one hand but massive deficit spending and debt on the other.  The dollar at noon was a bit lower against the euro, yen and Aussie dollar compared to readings this morning before the central bank announcement.  There had been some very big currency swings earlier involving commodity currencies, the Icelandic crown, and Korean won, but EUR/USD had been very stable.  In times of extreme uncertainty, the dollar’s most important relationship is prone to freeze, awaiting cues from elsewhere in financial markets.  The dollar stands to benefit from liquidating markets and a flight to safety, but conventional wisdom believes that it will eventually emerge from this crisis in a greatly weakened states.  When short-term support gives way to long-term reality is the $64,000 question.

Today’s statements show important differences.  The joint remarks agreed by all participating rate cutters lists five developments that justified today’s move in an order that likely ranks their importance.  They are 1) moderating inflationary pressure, 2) diminishing and well-anchored expected inflation, 3) an intensified financial crisis, 4) greater downside growth risks, and 5) lessening upside risks to inflation.  I doubt this is the order that the Fed and some others would have preferred but probably was needed to bring the ECB on board.  Credibility is preserved by putting price stability up front.  The Fed’s personal remarks lead with noting a markedly slower pace of economic activity and ominous implications for future growth from the more acute financial crisis.  Only later is reduced risks to future inflation mentioned.

The ECB’s regional remarks are confined to three sentences, all related to lessening upside price risks, the need to avoid second-order inflation, and the primacy of anchored price expectations as the most effective contribution that it can make to sustained growth and financial stability.

The Bank of England released the lengthiest statement, as it reported on its monthly policy rate meeting, which resulted in a changed stance.  One of the most interesting remarks was the admission that the substantial deterioration of the economic outlook “reflects a sharp monetary contraction.”  The failure by the Fed and other central banks to prevent a tumbling money stock in the 1930’s is widely blamed as the single most important cause of the Great Depression.  Assumptions that this knowledge should prevent such an economic catastrophe from occurring again has given analysts solace over these past six months.  But what if central banks try but are unable to prevent a shrinking money stock?  Even with years of massive quantitative easing, Japan’s rate of monetary growth remained very low when that policy was lifted in 2006.  The other comment that caught my eye was the sober confession that “cuts in officials interest rates could not be expected to resolve the current problems in financial markets and that a significant increase in the capital of the banking sector would be required.”  These revelations are hardly news to market players — hence today’s lukewarm market reception to the joint cuts — but seeing this view in a formal central bank statement gives it an added stamp of truth.  The likelihood of more interest rate reductions by the Bank of England and other central banks is summed up at the end of the statement: “During the past month, the balance of those risks to inflation in the medium term has shifted decisively to the downside.”  Here then is the deal: rates are being reduced not to solve the banking crisis, which is being addressed by other initiatives like the Gbp 50 billion  infusion of taxpayer money to recapitalize Britain’s largest banks, but rather in reaction to the devastating effects that this crisis is likely to exert on real activity, with a knock-on reduction of inflation.

The statement from the Bank of Canada acknowledges a significant tightening of local credit conditions, weakening export markets, and a fall in Canada’s terms of trade, all of which will swamp any boost from Canadian dollar depreciation.  Officials look for a “significant easing” of inflation pressure and for inflation expectations to remain well-anchored.  The statement promises that officials will keep monitoring developments and allows for the possibility that “further action might be required” to achieve its medium-term targets.

The Swiss National Bank eased less than the other rate cutters, but its benchmark rate (now 2.5% after 2.75%) is only higher than America’s among banks that acted today.  The statement notes that officials are reducing their forecasts for growth and inflation and justifies today’s action for that reason.  The SNB had tightened ten times between June 2004 and September 2007, being one of the few European central banks to tighten after the onset of the global credit crisis.  The next scheduled policy review is in December, but an earlier rate reduction, in my opinion, may be forthcoming depending on how badly global markets and the European economy perform.

The Swedish Riksbank had raised rates by 25 basis points as recently as September 4th as well as matching the ECB’s 25-bp increase in early July.  Moreover, today’s statement from the Riksbank asserted that “developments in Sweden to some extent differ from those in other countries.” Growth and inflation forecasts for Sweden were lowered by monetary officials, who also observed “higher interest rates for companies and households, lower capital wealth and increased uncertainty” as reasons to join today’s collective easing offensive.  Only the Riksbank remarks, moreover, stated the obvious intent of the gesture, namely that it “increases confidence and the likelihood that it {meaning rate cuts by any central bank] will have positive effects.  The Swedes believe the adage that collective monetary policy changes are better than individual changes and probably the corollary that coordinated currency market intervention as last done in September 2000 works better than unilateral intervention such as what the Japanese tried earlier this decade to cap yen strength.

Japan did not cut rates, a sufficiently conspicuous omission such that the Bank of Japan released a statement explaining why.  Japanese monetary conditions were called accommodative already, and the “financial market has been stable in comparison with those in other industrial countries.”  Apparently share prices do not count.  The Nikkei has plunged 40% this year, including 9.4% today, and the BOJ’s target interest rate remains unchanged from its level after being doubled to 0.5% in February 2007.  Officials at that Bank maintain that the banking crisis can be best addressed by liquidity injections and other ways to enhance the effectiveness of monetary operations and remain more worried about future inflation than deflation and recession.

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