The credit crisis is robbing the banks and other financial institutions of any capacity for funding, or for the provision of liquidity and, ultimately, for the financing of economic growth. If anything is indicative of the contractionary forces of a credit crisis, it is deflation in asset prices.
And there’s more. In the US, headline inflation is over 4 percent. This is due principally to rising commodity prices, but this dose of inflation is now disinflationary. Real wage growth has already turned negative in the US and, given that jobs are now being shed, it is unlikely that labour can recoup any loss in real wages. Today’s headline inflation is squeezing real disposable incomes and hence real growth in consumer spending and is compounding the contractionary forces of the credit crisis.
Stability in the US housing market is probably a necessary, though maybe not a sufficient, condition for stability in the credit markets. Even if the Fed steps into the market as a buyer of mortgage backed securities, this would still be treating symptoms and not causes. It might help if the Fed became a buyer of long term government bonds and, in this way, tried to influence mortgage rates. By so doing, this might help to steady the housing market, which might arrest or limit negative equity, which might also lessen defaults by encouraging those who feel burdened by negative equity, to ‘hang in there’.
However, given the extent of the weakness in the housing market and also the sheer magnitude of the problem, the Fed alone can’t resolve the housing problem. Intervention is likely to be required, such as the bail-out plan being considered right now by key policymakers in Washington. That said, every little bit helps, including policies aimed at relieving symptoms, like the Fed’s TAF (Term Auction Facility), the TSLF (Term Securities Lending Facility) and now its PDCF (Primary Dealer Credit Facility).
But the bottom line is that the expectation of asset price deflation needs to be reversed because the risk is not just more margin calls on leveraged positions and more distressed selling, or more counterparties ceasing to do business, but that the recession everyone now acknowledges the US has entered, deepens and is followed by a general bout of deflation.
So the Fed has to keep on cutting interest rates even if the widening spreads in the credit markets are currently frustrating its efforts to loosen monetary conditions. The short end of the Treasury market is telling the Fed it has at least another 150 basis points to go. And then there is another 150 basis points after that!
I think we’ll see a three-quarter point cut in the federal funds rate tomorrow and maybe even a full one percent cut.
My optimistic view on the equity market is being sorely tested but I shall run with it until the summer, by which time the federal funds rate should be much lower. I’m hopeful that this will then induce the expectation of better times ahead and a more promising outlook for profitability. I would have thought the prospect of an upswing in the cycle would encourage the expectation that earnings estimates will be revised up and, with that, valuations should look more appealing.
