A tightrope between inflation and recession
Up until the past few weeks, most central banks understandably fretted about higher asset prices, tighter credit spreads, faster money supply growth and higher inflation. Then, all of a sudden, everything changed. Credit markets suffered what might be...
Up until the past few weeks, most central banks understandably fretted about higher asset prices, tighter credit spreads, faster money supply growth and higher inflation. Then, all of a sudden, everything changed. Credit markets suffered what might be best described as a seizure.
In response, central banks were forced to abandon their medium-term focus on price stability and, instead, reprise earlier, long-forgotten, roles as lenders of last resort. It is not difficult to see why investors suddenly became a lot more nervous.
BNP Paribas, France's largest bank, froze billions of dollars of funds linked to the sub-prime mortgage market in the US. Countrywide and Washington Mutual, two of America's biggest mortgage providers, warned that difficult conditions in the mortgage market would adversely affect operations.
Countrywide talked about "unprecedented disruptions", adding that late payments and delinquencies were on the rise. Suddenly, financial markets seemed to be full of traps. Perhaps none of this should come as a surprise. After all, the US housing market has been in intensive care for well over a year now. Those exposed to the market were likely to be hit at some point.
These developments, however, go further than this. Creditors basically ran for cover. Recognising that some of their customers might not be quite as creditworthy as previously assumed, creditors collectively tried to reduce their exposure to risk.
Meanwhile, as credit lines dried up, those dependent on the liquidity previously provided by the banks were forced to seek other sources. Fire sales of other assets began, helping to explain the sudden lurch downwards in equity markets and the heightened volatility of the foreign exchange markets.
The increased demand for all things safe - notably cash - placed tremendous upward pressure on overnight interest rates. The gap between official rates set by the central banks and market rates began to widen. Monetary conditions were, therefore, tightening beyond the wishes of the central banks.
The ECB responded by offering loans to all-comers at four per cent, in an attempt to bring some order back into the European money markets. It ended up injecting around €100 billion of funds into the market on one day alone, 50 per cent more than was added in the immediate aftermath of 9/11.
The US Federal Reserve, Bank of Canada, Reserve Bank of Australia and Bank of Japan staged similar operations, although on a much smaller scale. Despite all their efforts, however, markets remained disorderly.
Whether these liquidity operations will ultimately work is, at this stage, impossible to answer. Financial markets so often switch from greed to fear and, when they do, the relationship between monetary policy, as defined by the level of official interest rates, and overall monetary conditions begins to fragment, as it did during the stock market declines in 2000 and 2001 and during the US credit crunch in the early-1990s.
If financial markets really are seizing up, central banks may eventually be forced to cut official interest rates, further extending their lender-of-last-resort roles. Many financial institutions would love to see just that. Lower rates would be just the tonic, it would seem, to restore financial market confidence, ensuring a return to business as usual.
But central bankers may be reluctant to go down this path, at least for the time being. After all, most of them still see inflation as a major risk. Some are still raising interest rates (the Koreans and Australians did so recently). Others, the Bank of England and ECB included, are still warning of higher interest rates to come. At the best of times, central banks have to walk the narrow path that runs between inflation dangers and recessionary risks. That path has narrowed over the last few days
Central banks have to consider two major risks. The first is the danger associated with failure to act. We live in a world funded mostly through capital markets and not so much by old-fashioned bank lending. Should capital markets implode, it will not be long before the global economy, too, implodes.
So far, there has primarily been an increase in liquidity risk. This might eventually translate into solvency risk, as part of a vicious downward spiral, triggering a series of unwelcome bankruptcies. With capital markets no longer able to provide the link between savers and investors, the global economy would eventually find itself in a very sorry state.
The second risk comes from cutting interest rates prematurely. In doing so, would central banks merely be reformulating the "Greenspan put"? This is the idea that central banks always stand ready to bail out investors, no matter how foolhardy they have been, for the sake of preserving the overall integrity of the financial system.
By doing so, they help foster the illusion that no one can really lose by playing the financial markets which, in turn, leads to excessive risk taking and too much liquidity, precisely the conditions central banks have spent so much time trying to bring to heel over the last two or three years. Arguably, the rate cuts associated with the bailout of Long Term Capital Management in 1998 led to these effects, contributing to the subsequent stock market hubris.
So what are central banks likely to do? They need to assess the situation carefully. There is no hurry to cut interest rates. At this stage, the global economy still looks strong. If, however, markets fall far enough and there are a couple of major financial market failures (in policymakers' eyes, a suitable punishment perhaps for earlier excessive risk taking) central bankers may be forced to act to preserve the underlying health of the global economy and its financial system.
However, if they do eventually cut interest rates, it would be wrong to think that this would mark the beginning of a new trend. Most of them, probably, would want to reverse rate cuts as soon as possible.
• This report was compiled by Peter Calleya, manager corporate strategy and research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.
In response, central banks were forced to abandon their medium-term focus on price stability and, instead, reprise earlier, long-forgotten, roles as lenders of last resort. It is not difficult to see why investors suddenly became a lot more nervous.
BNP Paribas, France's largest bank, froze billions of dollars of funds linked to the sub-prime mortgage market in the US. Countrywide and Washington Mutual, two of America's biggest mortgage providers, warned that difficult conditions in the mortgage market would adversely affect operations.
Countrywide talked about "unprecedented disruptions", adding that late payments and delinquencies were on the rise. Suddenly, financial markets seemed to be full of traps. Perhaps none of this should come as a surprise. After all, the US housing market has been in intensive care for well over a year now. Those exposed to the market were likely to be hit at some point.
These developments, however, go further than this. Creditors basically ran for cover. Recognising that some of their customers might not be quite as creditworthy as previously assumed, creditors collectively tried to reduce their exposure to risk.
Meanwhile, as credit lines dried up, those dependent on the liquidity previously provided by the banks were forced to seek other sources. Fire sales of other assets began, helping to explain the sudden lurch downwards in equity markets and the heightened volatility of the foreign exchange markets.
The increased demand for all things safe - notably cash - placed tremendous upward pressure on overnight interest rates. The gap between official rates set by the central banks and market rates began to widen. Monetary conditions were, therefore, tightening beyond the wishes of the central banks.
The ECB responded by offering loans to all-comers at four per cent, in an attempt to bring some order back into the European money markets. It ended up injecting around €100 billion of funds into the market on one day alone, 50 per cent more than was added in the immediate aftermath of 9/11.
The US Federal Reserve, Bank of Canada, Reserve Bank of Australia and Bank of Japan staged similar operations, although on a much smaller scale. Despite all their efforts, however, markets remained disorderly.
Whether these liquidity operations will ultimately work is, at this stage, impossible to answer. Financial markets so often switch from greed to fear and, when they do, the relationship between monetary policy, as defined by the level of official interest rates, and overall monetary conditions begins to fragment, as it did during the stock market declines in 2000 and 2001 and during the US credit crunch in the early-1990s.
If financial markets really are seizing up, central banks may eventually be forced to cut official interest rates, further extending their lender-of-last-resort roles. Many financial institutions would love to see just that. Lower rates would be just the tonic, it would seem, to restore financial market confidence, ensuring a return to business as usual.
But central bankers may be reluctant to go down this path, at least for the time being. After all, most of them still see inflation as a major risk. Some are still raising interest rates (the Koreans and Australians did so recently). Others, the Bank of England and ECB included, are still warning of higher interest rates to come. At the best of times, central banks have to walk the narrow path that runs between inflation dangers and recessionary risks. That path has narrowed over the last few days
Central banks have to consider two major risks. The first is the danger associated with failure to act. We live in a world funded mostly through capital markets and not so much by old-fashioned bank lending. Should capital markets implode, it will not be long before the global economy, too, implodes.
So far, there has primarily been an increase in liquidity risk. This might eventually translate into solvency risk, as part of a vicious downward spiral, triggering a series of unwelcome bankruptcies. With capital markets no longer able to provide the link between savers and investors, the global economy would eventually find itself in a very sorry state.
The second risk comes from cutting interest rates prematurely. In doing so, would central banks merely be reformulating the "Greenspan put"? This is the idea that central banks always stand ready to bail out investors, no matter how foolhardy they have been, for the sake of preserving the overall integrity of the financial system.
By doing so, they help foster the illusion that no one can really lose by playing the financial markets which, in turn, leads to excessive risk taking and too much liquidity, precisely the conditions central banks have spent so much time trying to bring to heel over the last two or three years. Arguably, the rate cuts associated with the bailout of Long Term Capital Management in 1998 led to these effects, contributing to the subsequent stock market hubris.
So what are central banks likely to do? They need to assess the situation carefully. There is no hurry to cut interest rates. At this stage, the global economy still looks strong. If, however, markets fall far enough and there are a couple of major financial market failures (in policymakers' eyes, a suitable punishment perhaps for earlier excessive risk taking) central bankers may be forced to act to preserve the underlying health of the global economy and its financial system.
However, if they do eventually cut interest rates, it would be wrong to think that this would mark the beginning of a new trend. Most of them, probably, would want to reverse rate cuts as soon as possible.
• This report was compiled by Peter Calleya, manager corporate strategy and research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.