Watch the thermostat!
Monetary policy normally works in the same way as a central heating system. You adjust the monetary thermostat - the policy rate - and wait for the economy to warm up or cool down. Sometimes the system fails; you press the switch and nothing happens.
Monetary policy normally works in the same way as a central heating system. You adjust the monetary thermostat - the policy rate - and wait for the economy to warm up or cool down. Sometimes the system fails; you press the switch and nothing happens. The same is true in the world of monetary policy. Sometimes, changes in the policy rate fail to have the desired economic impact.
Put another way, the effect of changes in policy rates on the economy depend critically on the viability of the financial system. This, so to speak, is the economy's plumbing system. A well-functioning financial system makes a central bank's job easy. A poorly functioning system is a headache.
Many people are puzzled by the Federal Reserve's decision to slash interest rates aggressively over the last few months. US inflation, after all, is above 4 per cent. In normal circumstances, rate cuts would simply not be justified. We live, though, in unusual times. Ben Bernanke and his colleagues at the Fed deliberately chose to place the issue of inflation to one side. The Fed has only one ambition: to fix the US economy's central heating system.
To understand what has gone wrong, one needs to know something about securitisation. Securitisation is the process by which banks package up their loans, turn them into marketable pieces of paper and then sell these pieces of paper to somebody else. For much of the current decade, securitisation boomed. Investors were happy to buy the banks' pieces of paper - typically known as asset-backed securities - because they offered better yields than government bonds and did not seem to be as dangerous as equities.
For a while, these pieces of paper were treated a bit like money. The more pieces of paper the banks were able to sell, the more people they could lend to. And so long as the ratings agencies continued to claim that the pieces of paper had some kind of intrinsic value, the underlying investors were happy. Lending boomed.
Unfortunately, lending quality deteriorated. In the second half of last year, investors (including the banks themselves) began to discover that the pieces of paper they had previously bought had suddenly lost their lustre. No one wanted to hold them. This new-found revulsion meant banks could no longer lend because they could not sell the paper.
The collapse of securitisation is gumming up the financial system. Without the ability to securitise, banks must find alternative sources of funds. That means higher deposit rates (good news for savers) but also, unfortunately, tougher standards for loans (bad news for homebuyers).
The story goes from bad to worse. During the earlier period of securitisation, too much money was chasing too few assets. Now, we are seeing the reverse: too little money chasing the available assets. House prices are falling and consequently banks will claw back their lending. In all likelihood, that means weaker consumer spending, slower economic growth and the very real possibility of recession.
The US housing market has been weak for a very long time but now the collapse in securitisation has begun to bite. House prices are collapsing. In response, consumer confidence is in free fall. It looks increasingly likely that consumer spending could actually contract this year, an outcome far worse than anything we saw during the last US recession in 2001.
How can this situation be resolved? Fortunately, there are some workable options. If banks can no longer securitise - and hence no longer lend - why not get someone else to securitise on their behalf? Governments can borrow cheaply. Perhaps, then, they should raise funds which can be lent to the banking system (indeed, the announcement from the US authorities that the government-sponsored enterprises known as Fannie Mae and Freddie Mac would be allowed to buy bigger mortgages is a move in this direction). Alternatively, perhaps the government should bypass the banking system altogether, borrowing cheaply to put cash directly in people's hands through a range of tax cuts (another policy being adopted in the US).
Then there is the "helicopter money" option. If the collapse of securitisation has led to massive cash hoarding, why not flood the system with cash to reduce the incentive to hoard? This could be done via the government selling bonds directly to the central bank. The money then raised could be pushed into the economy via tax cuts.
That some of these options are under active consideration by the US authorities says something about the seriousness of the problem. Cutting interest rates is only one part of the solution and, in any case, is not likely to have much of an impact unless the rate cuts improve banks' profitability, which is far from obvious.
Still, at least there is an active debate about how to deal with the failure of the central heating system in the US, irrespective of the controversial nature of some of the options.
• This report was compiled by the marketing department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.
Put another way, the effect of changes in policy rates on the economy depend critically on the viability of the financial system. This, so to speak, is the economy's plumbing system. A well-functioning financial system makes a central bank's job easy. A poorly functioning system is a headache.
Many people are puzzled by the Federal Reserve's decision to slash interest rates aggressively over the last few months. US inflation, after all, is above 4 per cent. In normal circumstances, rate cuts would simply not be justified. We live, though, in unusual times. Ben Bernanke and his colleagues at the Fed deliberately chose to place the issue of inflation to one side. The Fed has only one ambition: to fix the US economy's central heating system.
To understand what has gone wrong, one needs to know something about securitisation. Securitisation is the process by which banks package up their loans, turn them into marketable pieces of paper and then sell these pieces of paper to somebody else. For much of the current decade, securitisation boomed. Investors were happy to buy the banks' pieces of paper - typically known as asset-backed securities - because they offered better yields than government bonds and did not seem to be as dangerous as equities.
For a while, these pieces of paper were treated a bit like money. The more pieces of paper the banks were able to sell, the more people they could lend to. And so long as the ratings agencies continued to claim that the pieces of paper had some kind of intrinsic value, the underlying investors were happy. Lending boomed.
Unfortunately, lending quality deteriorated. In the second half of last year, investors (including the banks themselves) began to discover that the pieces of paper they had previously bought had suddenly lost their lustre. No one wanted to hold them. This new-found revulsion meant banks could no longer lend because they could not sell the paper.
The collapse of securitisation is gumming up the financial system. Without the ability to securitise, banks must find alternative sources of funds. That means higher deposit rates (good news for savers) but also, unfortunately, tougher standards for loans (bad news for homebuyers).
The story goes from bad to worse. During the earlier period of securitisation, too much money was chasing too few assets. Now, we are seeing the reverse: too little money chasing the available assets. House prices are falling and consequently banks will claw back their lending. In all likelihood, that means weaker consumer spending, slower economic growth and the very real possibility of recession.
The US housing market has been weak for a very long time but now the collapse in securitisation has begun to bite. House prices are collapsing. In response, consumer confidence is in free fall. It looks increasingly likely that consumer spending could actually contract this year, an outcome far worse than anything we saw during the last US recession in 2001.
How can this situation be resolved? Fortunately, there are some workable options. If banks can no longer securitise - and hence no longer lend - why not get someone else to securitise on their behalf? Governments can borrow cheaply. Perhaps, then, they should raise funds which can be lent to the banking system (indeed, the announcement from the US authorities that the government-sponsored enterprises known as Fannie Mae and Freddie Mac would be allowed to buy bigger mortgages is a move in this direction). Alternatively, perhaps the government should bypass the banking system altogether, borrowing cheaply to put cash directly in people's hands through a range of tax cuts (another policy being adopted in the US).
Then there is the "helicopter money" option. If the collapse of securitisation has led to massive cash hoarding, why not flood the system with cash to reduce the incentive to hoard? This could be done via the government selling bonds directly to the central bank. The money then raised could be pushed into the economy via tax cuts.
That some of these options are under active consideration by the US authorities says something about the seriousness of the problem. Cutting interest rates is only one part of the solution and, in any case, is not likely to have much of an impact unless the rate cuts improve banks' profitability, which is far from obvious.
Still, at least there is an active debate about how to deal with the failure of the central heating system in the US, irrespective of the controversial nature of some of the options.
• This report was compiled by the marketing department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.