Today the ECB has reduced its main refinancing rate (which is quivalent to the Fed funds rate)  by 75 percent points, the biggest amount in its short history. The Bank of England also cut its key rate by one percentage point to 2 percent and Sweden’s Riksbank lowered the same by the most since 1992. My attitude toward the ECB has been the same throughout this crisis. They’re more disciplined, because the financial state of the governments and citizens who they regulate is much better than that of their counterparts in the US. M. Trichet today showed some willingness to purchase some troubled paper directly, but whatever, and whenever this happens, its size and scope is likely to be far smaller than the Fed’s operations.

European Central Bank President Jean- Claude Trichet signaled he’s reluctant to cut interest rates so low that policy makers are “trapped” with few options to respond to a deepening recession.

“We have to beware of being trapped at nominal levels that would be much too low,” Trichet said at a press conference in Brussels today. The ECB earlier lowered its benchmark by three quarters of a percentage point to 2.5 percent, the biggest cut in its ten-year history.

Some of the ECB’s 21 policy makers have advocated a steady- hand approach to tackling the recession.

Council Split?

Luxembourg’s Yves Mersch told Luxembourg’s Tageblatt newspaper today that the bank is “entering calmer waters” with future rate changes more likely to be in the order of 25 basis points. Executive Board member Lorenzo Bini Smaghi said on Oct. 31 that “the present crisis is partially due to interest rates that remained at low levels for too long.”

“The council is split between those wanting to cut rates by only 50 basis points and those who wanted a more aggressive 100 basis-point cut,” said Juergen Michels, chief European economist at Citigroup Inc. in London. “So 75 basis points was a compromise and policy makers can keep their powder dry until February.”

Trichet said today’s decision was reached by “consensus,” and declined to divulge if there were calls for smaller or bigger cuts. ECB has reduced rates by 1.75 percentage points since October after the financial-market crisis intensified.

ECB forecasts published today show the euro-region economy will shrink about 0.5 percent next year, which would be its first full-year contraction since 1993. Inflation will average about 1.4 percent in 2009 and 1.8 percent in 2010, the new projections show, meeting the ECB’s price-stability goal of keeping the rate just below 2 percent.

“European policy makers, as we’ve seen in past global crises, continue to underestimate both the degree of the problem and their own part in its creation and solution,” Jim O’Neill, chief economist at Goldman Sachs Group Inc., said in a Bloomberg Television interview. “I prayed that the ECB would do 100. At least they didn’t do 50.”

Manufacturing and service industries contracted at the fastest pace on record in November and economic confidence plunged to a 15-year low. With oil prices collapsing, the inflation rate fell the most in almost 20 years last month, to 2.1 percent from 3.2 percent in October.


While “global and euro-area demand are likely to be dampened for a protracted period of time,” lower commodity prices may support a gradual recovery from the second half of next year, Trichet said.

As well as cutting rates, the bank has flooded money markets with cash and widened its collateral rules to unfreeze credit markets. Trichet said today it may be possible for the ECB to purchase assets and securities outright, while declining to say if it would.

With those who don’t receive unemployment payouts included, the total joblessnumber is close to 6 million now:

The number of people on unemployment benefit rolls rose to 4.09 million in the week ended Nov. 22, the most since December 1982. A separate report showed orders at U.S. factories tumbled in October by the most in eight years as demand collapsed at home and abroad.

AT&T Inc., DuPont Co. and Viacom Inc. today announced plans to eliminate more than 15,000 jobs as consumer spending falters and the recession deepens.

Figures from the Commerce Department showed factory orders dropped 5.1 percent, the biggest decline since July 2000. Excluding transportation gear, bookings decreased for a third consecutive month.

Fed Perspective

Dennis Lockhart, president of the Fed Bank of Atlanta, told a conference in New Orleans the economy was “in the midst of a long and very painful adjustment process.” Chicago Fed President Charles Evans, speaking in Dearborn, Michigan, said the U.S. faced a “very substantial downturn.”

Trending Up

The four-week moving average of initial claims, a less volatile measure, climbed to 524,500, the highest since 1982, from 518,250, today’s report showed.

The unemployment rate among people eligible for benefits, which tends to track the jobless rate, increased to 3.1 percent, the highest since 1992, from 3 percent. These data are reported with a one-week lag.

Forty-nine states and territories reported an increase in new claims, while 4 reported a decrease. The biggest increases were reported by California, Ohio and Michigan.

Longer Slump

What started as a housing slump has spread to manufacturing and services. The Institute for Supply Management’s factory index dropped last month to the lowest level since 1982, and its services gauge, which accounts for almost 90 percent of the economy, fell to the lowest level since records began in 1997.

Financial firms are among those making the biggest job cuts. JPMorgan Chase & Co., the largest U.S. bank by assets, said this week it will cut 9,200 jobs nationwide at Washington Mutual Inc. as it acquires the Seattle-based lender.

“We have seen a fairly significant dropoff in demand, starting in October,” Delta Airlines Inc. President Ed Bastian said on a Webcast of a Credit Suisse Group AG airline conference in New York this week. “The revenue environment is as cloudy as it’s ever been. We’ve never seen the level of demand destruction that some are forecasting for our business.”

Delta, the world’s largest carrier, said it will cut seating capacity by as much as 8 percent in 2009 and eliminate an unspecified number of jobs.

The SIV story is not entirely over yet, and Bloomberg today reports that the creditors of the failed SIV “Sigma” may not paid “in full or in part”. In other words, they may get zero cent(s) on the dollar…

Sigma, which held securities with a face value of $2 billion, according to Moody’s Investors Service, raised a total $306 million from a Dec. 2 auction as part of its liquidation, the SIV’s receivers Ernst & Young LLP said in a statement today. Sigma has $6.2 billion of secured debt outstanding, the receivers said.

“Short-term liabilities which fell due for payment after Oct. 23, 2008 will not be met either in full or in part out of these assets,” the statement said. The liquidation follows a judgment by the U.K. Court of Appeal and the receivers said their estimate may change should the case go before the House of Lords.

Sigma, created by London-based Gordian Knot Ltd., survived longer than other SIVs that defaulted after money markets shut down by borrowing from banks through collateralized loans known as repurchase agreements. Sigma stopped paying creditors at the end of September after failing margin calls, according to court documents.

Sigma pledged $25 billion of its assets to banks to cover $17.4 billion of borrowings, according to Moody’s, leaving just $2 billion of unencumbered assets to repay about $6 billion of outstanding bonds.

Senior creditors in Cheyne Finance Plc, the first SIV to collapse, recovered about 61 percent after the company was reorganized, according to an Aug. 12 statement.

Not only hedge funds suffer redemptios. Mutual funds are also facing something of a run by worried investors nowadays. One positive development is the return of investors to money market funds, which is for now preventing some investment grade companies from falling apart:

Investors fled from stock and bond mutual funds for the third straight month in November, removing $86.4 billion as signs of a worsening economy drove them out from all but the safest investments.

Shareholders removed $52 billion from stock funds and $34.4 billion from bond funds last month, said Conrad Gann, chief operating officer of TrimTabs Investment Research, citing preliminary data compiled by the Sausalito, California-based firm. While outflows were less than a record $111 billion in October, investors are still scared, he said.

“There’s still plenty of fear out there,” Gann said. “It’s more of a continuing drumbeat.”

Stock and bond mutual funds have lost $270 billion to investor withdrawals since September. Every bond-fund category has lost ground in 2008 except those that invest in U.S. Treasuries.

Cash has poured into money-market funds, considered the safest investments outside of bank deposits and government-backed bonds. Taxable money-market mutual fund assets surged to a record of $3.657 trillion in the week ended Dec. 2, according to IMoneyNet of Westborough, Massachusetts.

Drop Since May

Mutual funds had $9.6 trillion in assets as of Oct. 31, a 22 percent drop since May, according to data compiled by Washington, D.C.-based Investment Company Institute.

Merril Lynch says that oil may fall to $25 per barrel if China falls into a recession:

Crude oil fell below $44 a barrel to the lowest since January 2005 and gasoline dropped below $1 a gallon as the deepening recession in the U.S., Europe and Japan cuts fuel consumption.

Prices may dip below $25 a barrel next year if the recession spreads to China, Merrill Lynch & Co. said in a report today. “We’ve got the U.S, U.K., Europe and Japan all in recession for the first time since World War II, and the oil market is reacting,” said Chip Hodge, a managing director at MFC Global Investment Management in Boston, who oversees a $5 billion energy-company bond portfolio.

Oil prices have tumbled 70 percent since reaching a record $147.27 on July 11.

 “There is no sign where it will stop,” said Tom Bentz, senior energy analyst at BNP Paribas in New York. “We are now looking at $41.15, which was the pre-Gulf-War high and after that at the $40 and $37 level.”

Oil reached a then-record $41.15 in October 10, 1990, when Iraqi troops were occupying Kuwait. The milestone held until May 2004. Prices were last below $40 a barrel in July 2004.

“A temporary drop below $25 a barrel is possible if the global recession extends to China and significant non-OPEC cuts are required,” Merrill commodity strategist Francisco Blanch said in today’s report. “In the short run, global oil-demand growth will likely take a further beating as banks continue to cut credit to consumers and corporations.”

OPEC oil ministers agreed on Oct. 24 in Vienna that the 11 members with quotas would cut supply by 1.5 million barrels a day starting in November.

“Prices won’t rebound until either the financial crisis is fixed or oil-market fundamentals tighten,” said Michael Lynch, president of Strategic Energy & Economic Research, in Winchester, Massachusetts. “We will have to see substantial inventory reductions and OPEC cuts.”


On September 11th I wrote here:

“If conditions remain as they are now, if unemployment continues to rise, and financial markets remain in their present panicky situation, I’m convinced that we’ll get further rate cuts from the Federal Reserve.

How soon will this be? The timing will not be decided by data or by the central bank itself, but by markets. If the terrible state of the financial markets continues in its present shape, the Federal Reserve will have to act rather soon.

I believe that they will cut a few times before 2008 is over.”

Today central banks have reduced rates by fifty basis points in a joint action, which was joined by the People’s Bank of China in an independent move. VIX, on the other hand, rose to another all-time intraday record of 58.36, breaking the previous record for the second time this week.
From the Fed:

“For release at 7:00 a.m. EDT
Joint Statement by Central Banks

Throughout the current financial crisis, central banks have engaged in continuous close consultation and have cooperated in unprecedented joint actions such as the provision of liquidity to reduce strains in financial markets.

Inflationary pressures have started to moderate in a number of countries, partly reflecting a marked decline in energy and other commodity prices. Inflation expectations are diminishing and remain anchored to price stability. The recent intensification of the financial crisis has augmented the downside risks to growth and thus has diminished further the upside risks to price stability.

Some easing of global monetary conditions is therefore warranted. Accordingly, the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, Sveriges Riksbank, and the Swiss National Bank are today announcing reductions in policy interest rates. The Bank of Japan expresses its strong support of these policy actions.

Federal Reserve Actions
The Federal Open Market Committee has decided to lower its target for the federal funds rate 50 basis points to 1-1/2 percent. The Committee took this action in light of evidence pointing to a weakening of economic activity and a reduction in inflationary pressures.

Incoming economic data suggest that the pace of economic activity has slowed markedly in recent months. Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit. Inflation has been high, but the Committee believes that the decline in energy and other commodity prices and the weaker prospects for economic activity have reduced the upside risks to inflation.

The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh.

In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 1-3/4 percent. In taking this action, the Board approved the request submitted by the Board of Directors of the Federal Reserve Bank of Boston.

Information on Actions Taken by Other Central Banks
Information on the actions that will be taken by other central banks is available at the following websites:

Bank of Canada
Bank of England
European Central Bank
Sveriges Riksbank (Bank of Sweden)
Swiss National Bank”

Of course, all this is aimed at reducing panic in financial markets, and it will have an effect on the severity of the crisis in some of thiese nations. But it will neither ease the credit crisis, nor prevent bankruptcies, because it’s too late by now. I called for international intervention many times, but central bank action alone is not enough, because the difficulties in interbank markets, and credit markets in general are not born of any clear problems about borrowers, but from the problems of lenders themselves. What does that mean?

As I have stated before, the banking system has no desire to function until it has gone through a period of natural selection, which eliminates the weakest players, and leaves those that remain to deal among themselves without worrying about counterparty risk. The central banks are fighting this trend, but they cannot win because they’re dealing with sophisticated actors who know only too well how bad the balance sheets of hundreds of medium and large institutions around the world are. No level of interest will induce them to lend as long as they’re unsure about recovering the principal. The one and only solution to this problem is a string of bankruptcies, and until we have seen hundreds of banks in the US, and tens of banks in Europe and elsewhere fail, the crisis will continue. Short of buying all the bad mortgage, consumer, corporate debt in the system, nothing that the governments do will solve this crisis.

And why does it have to be that way?

Because it’s too late by now. The problem has spread to every single part of the global economy, and has reached monstrous proportions. Central banks, as financial actors, have only a very indirect impact on the countless credit channels that have now been blocked. For instance, while the libor serves as a benchmark for many purposes, the rate itself is only useful for uncollaterised interbank lending on a period of between 0-30 days. It has an ignorable effect on risk premiums in capital markets, and, in the present circumstances, no effect at all on banks’lending plans. To put it in another way, overnight libor was at 2.97 on Monday, today it is at 4,52. The difference is similar to the rate cut of today by central banks. In other words, in an environment of extreme volatility even in overnight rates, central bank target rates lose most of their significance.

Indeed, the Fed, and to a lesser extent many other central banks, have a lot of difficulty maintaining their overnight target rate through their market operations.

Of course, while it’s not very useful, reducing rates is what central banks can do, and their attempts should be supported, even applauded. But expecting that these actions can end this crisis is not a logical and realistic assumption.

So when will the crisis end? It will end when Asians finance the bailout of the US financial system, or, if that doesn’t happen, it will end when unemployment reaches double digits, S&P reaches 500, and thousands of firms become bankrupt. My own expectation for S&P 500 is 500 for 2009.

Overnight U.S. dollar funding costs fell to 2 percent as of this hour after central bank action, 4 am New York time, compared with around 5 percent yeasterday in Europe and as high as 8.5 percent in early Asian trading today. Traders in Singapore and Malaysia said while overnight U.S. dollar funds were quoted between 6 and 7 percent, some deals took place at levels as high as 8 and 8.5 percent.


Central banks across the world are finally pumping massive amounts of liquidity in the short term markets in order to ease the recent unprecedented collapse in credit markets.


South Korea’s central bank is injecting dollars into the local dollar/won swap market as it is facing ‘an excessive imbalance’. Bank of India intervened to stop dollar’s rise against the rupee. Hong Kong’s central bank injected HK$1.556 billion (US$199.5 million) into the interbank market as short term funding tightened and the Hong Kong stock market fell more than 7 percent.


The Fed has doubled the amount on offer through its swap lines to the major central banks of the world, and the total amount has been quadrupled, as short term dollar funding activity is frozen. The doubling appears to have been an arbitrary choice, essentially a jump to the largest near integer to deal with the massive and sudden vacuum in the credit markets in general.


Excerpts from Fed’s Statement of 3 am New York time:


“Today, the Bank of Canada, the Bank of England, the European Central Bank (ECB), the Federal Reserve, the Bank of Japan, and the Swiss National Bank are announcing coordinated measures designed to address the continued elevated pressures in U.S. dollar short-term funding markets.”


“Federal Reserve Actions


The Federal Open Market Committee has authorized a $180 billion expansion of its temporary reciprocal currency arrangements (swap lines). This increased capacity will be available to provide dollar funding for both term and overnight liquidity operations by the other central banks.


The FOMC has authorized increases in the existing swap lines with the ECB and the Swiss National Bank. These larger facilities will now support the provision of U.S. dollar liquidity in amounts of up to $110 billion by the ECB, an increase of $55 billion, and up to $27 billion by the Swiss National Bank, an increase of $15 billion.


In addition, new swap facilities have been authorized with the Bank of Japan, the Bank of England, and the Bank of Canada. These facilities will support the provision of U.S. dollar liquidity in amounts of up to $60 billion by the Bank of Japan, $40 billion by the Bank of England, and $10 billion by the Bank of Canada.

All of these reciprocal currency arrangements have been authorized through January 30, 2009.”


All these banks are announcing overnight repos around now.


Update: Central banks have been acting through morning and noon.


After central bank injections, overnight dollar is down to 3.84% today 7am New York time, from 5.03% yesterday. However, three month dollar libor is still climbing, to 3.20% from 3.06%.


Later, through 9 am, New York Federal Reserve added a combined total of $105 billion of temporary reserves to the banking system through repos, exceeding the biggest day’s combined total in September 2001. Overnight rates finally settled around three percent.



From Reuters:

“The U.S. Federal Reserve added $50 billion in temporary reserves to the banking system on Tuesday, according to the New York Federal Reserve web site.

Earlier on Tuesday, the Fed said it would arrange a big overnight repurchase agreement and was ready to arrange further operations later in the day as needed.

As the fallout from Lehman Brothers’ collapse at the weekend continued to infect financial markets, the interest rate banks demanded for lending dollars overnight to other institutions ballooned to more than five times the U.S. Federal Reserve’s 2 percent target rate.

London interbank offered rates (Libor) for overnight dollars as fixed by the British Bankers Association — which trillions of dollars of derivative, financial and corporate contracts are referenced against — soared to 6.43750 percent

‘In addition, at around 9:30 a.m. (EDT) the Desk will conduct its typical Tuesday morning $20 billion, 28-day single-tranche repo, settling 1-day forward,’ the New York Fed said in a statement on its Web site.

After the operation, federal funds traded in the U.S. interbank market slipped to 2.0 percent, matching the target rate the Federal Reserve sets, from 3.0 percent earlier on Tuesday. ”

Commentary: The bid-ask spread on overnight dollar has widened to extreme levels, drying out interbank liquidity. The Fed is injecting large amounts of short-term liquidity in order to prevent a cascade of bankruptcies at international institutions. It appears that the Fed will be forced to bailout AIG at some point. The psychological intensity of the situation is probably more than they can bear.  

At about the same time, ECB offered 70 billion euros ($100 billion) in a one-day refinancing operation, with 56 banks bidding for a total of 102.5 billion euros. The Bank of England injected 20 billion pounds ($36 billion).


According to this article at the Wall Street Journal, the FDIC has been urging the Office of Thrift Supervision, which is a division of the Treasury Department, to be more active and stringent in urging banks to strengthen their balance sheets. According to the same article, the OTS isnt very fond of the idea of pressing on banks. This is hardly surprising – it is the FDIC that will have to pay the depositors, and eventually reorganise these banks somehow, which is going to drain its reserves. There are more than 8400 banks in the United States, and a sustained streak of failures could put in jeopardy the strength of any insurer, however well-prepared it may be.


Sheila Bair has so far been relatively open about the risks to the banking system, given the secretive nature of her profession. She has given the public repeated warnings about the prospect of banks failures, while at the same time trying to inspire some sort of confidence by insisting that the government is in control of the situation.


But it is not enough that this serious matter is being dealt with by relatively lower ranking members of the government. There’s no reason to wait until the problem reaches catastrophic proportions. The credibility of Mr. Paulson’s intervention in the GSE issue has suffered for the reason that also made his sponsorship of last year’s SIV deal a failure – too little, too late. He and Mr. Bernanke seem to be unable to grasp the need for preemptive, far-sighted solutions, choosing instead to focus on saving the day. To see that the economic situation is not going to get any better any time soon requires only a brief glance at two pieces of data: FED’s lending survey, and mortgage defaults. And under these conditions, if the government is to have any credibility, it must act preemptively and with clear goals. Otherwise the patchwork of impromptu solutions is likely to be torn apart in the whirlpool of financial turmoil.  


As year end approaches, funding pressures are likely to intensify, along with bank failures. There’s even a possibility that some large bank will also default on its obligations.  The last two months of last year were nightmarish for interbank funding, and now, with the ECB actually discussing reducing or closing the window of lending for certain types of collateral, we’re likely to see an even worse year end scenario. Arguably the worst will hit British and Spanish banks, as they have been increasingly turning to the ECB to deal with problematic paper, but the general air of insecurity should permeate all sectors of the financial market, from bonds and currencies, to credit default swaps.


Banks failures are accelerating. It is certainly possible that they will reach levels of the savings and loans crisis. As demonstrated by the OIS spread, institutional actors already have little confidence in each other, what is not needed now is panic by the public. The FED and the Treasury already have considerable difficulty managing the relatively sophisticated players of the financial system, and a generalization of the problems is the last development that we need.  

Ineffective Monetary Policy

August 26, 2008

Monetary policy in the modern age dictates that a central bank should provide liquidity and expand credit during a slowdown or financial crisis. But this time there’s every sign that isolated strong action by a single central bank is not only ineffective, but also counterproductive.

Of the major central banks of the world, only the Federal Reserve responded to the financial crisis with aggressive rate reductions. The ECB has chosen to interprete its legal mandate strictly, and has actually increased rates in response to inflation that has recently reached 4 percent. Rising inflation and rapidly deteriorating economic outlook has prevented Bank of England from acting decisively, while Bank of Japan has chosen to remain neutral but fearful, with rates already near zero. Brazil, Turkey, Thailand, China, Russia, India all face significant inflationary pressures, and some have been forced to raise rates in order to combat the risk of runaway inflation, which so far seems to have materialised only in Vietnam.

In the US and to a lesser extent in the EU, credit growth decelerated sharply, with banks and financial institutions tightening some forms of credit to unprecendented levels; in contrast, in most emerging markets money supply has continued to expand strongly, invigorated by flows of short term money from the industrialised world seeking better yield. Exacerbated by the parabolic rise in commodity prices, mostly a result of the falling dollar, the already heated economies of these developing nations have been grappling with increasing inflationary issues ever since the Federal Reserve began its rate cut cycle in September of last year.

The argument that rate reductions by the FED have prevented the situation from worsening in the US is devalued by the fact that in the Eurosystem the experience of financial institutions has not been any better or worse than those in the US. European banks have had massive exposure to problematic US paper, and some of the worst write-downs have been taken by a Swiss institution.

What is more, because of the lagged effect of constricted credit channels, the stimulative effect of reduced rates on the real sectors of the economy have been hardly felt so far. A shutdown of credit sources to non-financial institutions is far from being the case, both in Europe and the US, and central bank interventions have not prevented banks from shrinking balance sheets and squeezing credit where they believed it to be be necessary.

What then, has been the achievement of monetary policy thus far?

In the US, the result has been the falling dollar, and high inflation. Neither the fear premium on LIBOR, nor  mortgage rates have been ameliorated by lower rates. And the near failure of Bear Sterns occurred at a time when the Federal Reserve had already reduced rates by about 200 basis points from their August 2007 levels. Reduced rates, and even the new and innovative liquidity facilities announced by central banks, have not been successful in preventing financial participants from nervously speculating on who is to fall next.

In the rest of the world, where stimulus wasn’t needed, the Fed’s inflation gift, via the lower dollar, has forced central banks to increase rates, making sure that the only parts of the world where growth was relatively unhurt by the financial crisis would now be on the inevitable path to recession because of high interest rates necessitated by inflationary pressures.

The impact of the Fed cuts on the global economy has been mostly negative. The global recession that’s yet to be experienced in its full force is likely to be long lasting and painful.