Wednesday, January 30, 2008

Just a week after cutting interest rates by 0.75%, the Fed has cut US rates again by 0.5%. The US economy is certainly in need of stimulus. In the last quarter of 2007, growth was barely above zero, and it looks likely that growth will turn negative this quarter.

It is too early yet to assess how the markets have responded to the move. New York markets initially responded well, but by the end of the day have fallen back considerably. The interest rate cut itself is good - the signal it sends about the severity of the malaise to which it is a response is bad news.
In an attempt to avoid further bank runs similar to the Northern Rock experience, it is being proposed that the Bank of England should be able to lend banks money without the loans being made public. There are clear benefits and drawbacks associated with this proposal.

The benefit is that, in the case of Northern Rock, the bank run was precipitated by disclosure of the fact that the company was in sufficient trouble to require special help from the Bank of England. Much in this sphere depends on confidence, and it was disclosure that eroded the public's confidence in the bank. So, the argument goes, take away disclosure and you take away the thing that saps public confidence and causes the bank run.

There are two drawbacks. The first is that taxpayers, if they are to make sensible choices at the ballot box, should know how their money is being spent. If bailouts of banks are to be kept secret, we won't know. So long as disclosure is required after a certain time period has elapsed, this problem need not be severe. The shorter the period, the less serious the problem. But also, the shorter the period, the more likely it is that the bank being helped is not yet out of trouble. Nothing has yet been said about how long this period should be - but it is clearly a crucial issue.

The second drawback is that an information vacuum tends to suck in rumour. This carries the risk that the next victim of a bank run will be an organisation that is financially very secure. The problem is that we need information about banks so that we know that we can trust them - but we need not to have information about banks that might fail. Unfortunately, though, the absence of information would mean that we knew everything that we need to know. Now there's a paradox.

And it implies that the true source of the problem lies elsewhere - in the fundamentals of banks' balance sheets. Tinkering at the edges, making information secret, is cosmetic surgery. The system needs more than that to put things right.

Tuesday, January 22, 2008

The US Federal Reserve today cut interest rates by 0.75% points. This is a week before the time of the month when the Fed would normally be expected to adjust rates, and has come int he wake of a significant crash in the stock market. Is this a timely and appropriate response to current economic conditions, or does it reflect panic?

Curiously, the answer is both. For the Fed walks a tightrope in deciding by how much to cut rates. Clearly the American economy is in dire need of a big stimulus. But the bigger the stimulus, the clearer the signal that things are not going well, and the more sapping is the effect on consumer confidence - and hence on spending. It is not yet clear on which side of the tightrope the Fed has trodden today - or whether it has got things exactly right.
The markets have got the jitters. Actually that's something of an understatement, with the FTSE having experienced its largest one-day drop since 9/11 yesterday. The panic amongst equity sellers is fuelled by fears of a recession in the US - something that I have been flagging on this blog for many months now. The signs are that the American economy is heading for a sharp reverse. While some of the more complacent observers note that the UK economy is in better shape (and indeed it is), the old adage that when America sneezes the rest of the world catches a cold remains true - at least when America sneezes with the kind of gusto that one can expect now.

As recently as this weekend, the Telegraph was arguing that higher interest rates should be the order of the day in the UK. It is certainly the case that inflation is a threat - given higher fuel and food prices. But, so long as wage pressure can be contained, the much more serious threat is recession. To stave off this threat, it is likely that both further interest rate cuts and a fiscal injection (an increase in the government's budget deficit) will be necessary. There are some (really) tough times ahead.

Thursday, January 10, 2008

The Bank of England has kept interest rates on hold this month. This is in the face of mixed signals about where the economy is heading.

Inflation has remained steady at 2.1%. But prices for food and fuel have been rising, and there is concern that this might stoke up some inflationary pressure. At the same time, the housing market has slowed considerably, and important trading partners (including the United States) appear to be heading for recession.

In normal times, monetary policy (conducted primarily through the central bank adjusting the interest rate) can be used to regulate the economy, and it does a pretty good job. When the economy is overheating, inflation is a threat and unemployment is low - and an interest rate hike can serve to reduce demand thereby curtailing inflation. Likewise, an interest rate cut helps to stimulate demand when unemployment threatens.

The problem we have now is that we are not in normal times. Both inflation and unemployment are viewed as threats on the horizon.

Which way then for the interest rate? I would argue that it should come down in order to protect the economy from recession. There are hazards in this - most obviously, cutting the interest rate could fuel inflation at a time when prices are rising anyway. But the price rises that we have seen are one-shot increases due to specific factors - so long as wages are kept under control, there is no reason for these to generate a sustained increase in inflation.

The prime minister has, this week, stressed the need to keep public sector pay settlements down. This does not signal a return to the ill-fated incomes policies of the 1970s, but it does operate on people's expectations. The chances of a wage-price spiral occurring are much reduced if people do not expect large wage hikes.

To sum up, the direction of change for the interest rate should still be downward - though this month the Bank of England is probably right to wait, if only to ensure that the government's warnings on pay settlements are heard over the coming period.

Friday, January 04, 2008

Chancellor of the Exchequer, Alistair Darling, has announced new powers for the UK's Financial Services Authority (FSA). These come in the wake of the UK's first bank run for over 100 years - the now infamous case of Northern Rock. The new powers will allow the FSA to protect customers' cash if a bank gets into financial difficulties, hence giving customers priority over banks' other creditors. The FSA will also have new powers (and duties) to ensure that banks in difficulties do not suffer cash flow problems.

The new powers will become part of legislation to be passed in May of this year, following a consultation period. Broadly they are to be welcomed. There are some gaps that need to be plugged, however. Currently, responsibility for the security of the banking system is shared between the FSA, the Bank of England, and the Treasury (headed by the Chancellor of the Exchequer). That nebulosity of responsibility did not facilitate decision making in the face of Northern Rock. The new legislation needs to make very clear exactly who is responsible for what, and how the three bodies should work together. Mr Darling's preferred model is one in which the FSA and Bank of England have input, but where the final responsibility is the Chancellor's. This is a good model in that someone has clear responsibility. What needs to be worked out, though, is the nature of the input of the other two bodies - they each have information and the institutions need to be in place to ensure that each is heard.