Sticky situation

Central banks attempted damage limitation to prevent the crisis in the financial markets spilling over into the real economy. But more than one year on the institutions come under fire as policies are tested and found wanting. Tomas Hirst reports.

A year on from what is commonly considered the start of the credit crisis the world economy is still reeling from the unwinding of the excesses in the financial sector. The past 12 months have offered an unprecedented challenge to central banks with turmoil in financial markets worsened by a surge in commodities prices.

The collapse of the subprime mortgage market in America forced many international banking institutions to write down the value of a significant amount of the mortgage-backed securities they held on their books. The mortgage defaults that the collapse entailed impacted on the American housing market, driving prices down and increasing the difficulties of individuals to finance themselves.

Kenneth Rogoff, in his paper “Impact of Globalization on Monetary Policy” given at the Federal Reserve’s annual Jackson Hole symposium in August 2006, suggested that the comfortable global environment over the past decade had left central bank policies untested.

Rogoff, who previously served as chief economist at the International Monetary Fund and also at the Fed, said “it remains very much an open question of what will happen if the system is stress tested, say by a combination of a housing price collapse in the United States and a sharp slowdown of growth in China.”

A year on Rogoff’s perfect storm of an American housing collapse and a slowdown in emerging market growth appeared a worryingly accurate prophecy. Central bankers were faced with a liquidity squeeze that threatened to cause a systematic failure in the banking system as companies struggled to plug the holes in their balance sheets.

The Federal Reserve responded robustly to the crisis dropping the Federal Funds target rate incrementally from 5.25% to 2% between September 18, 2007 and April 30, 2008. The moves included a three-quarter point reduction on January 21, 2008 at an extraordinary meeting, which sent shockwaves through the market as interpretations differed as to whether the Fed was acting decisively or out of panic.

The Bank of England moved more gradually keeping its basic interest rate steady at 5.75% until December 6, 2007 before dropping it by a quarter point. Two further quarter point reductions saw it brought down to its current level of 5% while the European Central Bank (ECB) left its rate at 4% until July 3, 2008 when it raised it to 4.25%.

Each of the central banks have come under criticism for their actions, although the Fed has come under particular scrutiny by virtue of the scale of its actions and the bail-out of Bear Stearns.

In this year’s Jackson Hole Symposium Ben Bernanke, the Fed chairman, said its policies had been aimed at limiting the potential repercussions of the banking crisis on the real economy and avoiding the threat of a systematic failure.

“In easing rapidly and proactively, we sought to offset, at least in part, the tightening of credit conditions associated with the crisis and thus to mitigate the effects on the broader economy,” he said.

Not all of his fellow delegates at the convention, however, saw Fed policy as being able to achieve this aim over the long term. In the most dramatic moment of the symposium Willem Buiter, a former member of the Bank of England’s Monetary Policy committee, submitted a paper attacking the responses of central banks to the crisis.

Although he criticised the Bank of England for its sluggish initial response as the crisis unfolded his most stinging attack was saved for theFed, which he accused of both using ineffective tools to stimulate growth and breaching its own mandate in the process.

“I find that the Fed performed worst as regards macroeconomic stability and as regards one of the two time dimensions of financial stability – minimising the likelihood and severity of future financial crises,” says Buiter.

One of the main failings of the Fed in this regard was, he says, the fact that the Federal target rate is an ineffective tool for addressing liquidity and insolvency issues and as such the Fed’s drastic three and a quarter point drop provided an insufficient solution to the problems faced by the banking sector.

On this subject Buiter is supported by Stephen Cecchetti, a former executive vice-president and director of research at the Federal Reserve Bank of New York, as well as associate economist of the Federal Open Market Committee. In his paper entitled “Monetary Policy and the Financial Crisis of 2007-2008” Cecchetti argued that in hindsight “traditional interest rate instruments proved to be ineffective [to ease the problem of financial intermediaries finding essential short-term financing]”.

Although Buiter focused his attack on the Fed the same criticism can just as easily be levelled at the Bank of England. Despite three rate cuts, which did little to help ease rising inflation figures, which were spiralling above the banks’ 2% target rate, the spreads between the Bank’s base rate and the London Interbank Offered Rate (Libor) remain high.

Richard Batty, a global investment strategist at Standard Life Investments, says the continuing higher spreads prove that the credit crunch is still with us.

“If you look at the level of Libor relative to policy rates it is obvious that spreads are much higher than they were a year ago,” he says. “Elevated Libor spreads suggests that problems have not gone away so there’s still room to go.”

Unlike the Bank of England, the policies undertaken by the Fed, however, have been interpreted as prioritising signs of economic weakness over inflationary concerns on the back of global increases in the prices of food and fuel.

Buiter suggests that by dropping target interest rates as they did the Fed was, in effect, changing a nominally triple mandate of maintaining maximum employment, long-term price stability, and moderate long-term interest rates into a single short-term growth mandate.

Certainly the Fed seemed less concerned with the threat posed by rising headline inflation figures than with the possibility of the country going through an economic recession. This can be explained in part by the fact that core inflation, which does not take food and fuel costs into account, remained relatively stable over the credit crunch and the Fed, unlike the Bank of England and ECB, uses core inflation as its central long-term indicator of inflationary trends.

This, says Gabriel Stein, the chief international economist at Lombard Street Research, is an indictment of Fed action since ignoring non-core inflationary pressures ignores the effect of higher food and energy costs on consumers.

“What the Fed was doing was a panicky gut reaction, which has become a self-fulfilling prophecy,” he says. “By slackening interest rates the Fed exacerbated inflation by pushing money into commodities.”

Oil producing countries blamed the surge in commodity prices on speculation, suggesting that investors pumping money into oil futures was pushing up the price instead of supply constraints. Western economies, in turn, blamed spiralling headline inflation figures on the increasing cost of imports and put pressure on the oil producers to increase supply.

Their arguments prompted Buiter to jokingly suggest that if both are taken at face value the only way in which rising inflation could be explained is through the existence of interplanetary trade.

Although the impact of global factors on longer-term inflationary trends has helped to weaken the control of individual central banks over the trajectory of interest rate movements, they can still use the interest rate tools to effectively control short- and medium-term inflationary trends.

In 2006 Rogoff suggested that rising inflation might be a deliberate aim for a central bank, or at least a beneficial side-effect under certain economic conditions.

“Central banks may reasonably choose to allow inflation to drift below target in response to favorable terms of trade shifts, just as they may choose to allow inflation to drift temporarily above target in response to adverse oil price shocks,” he says.

In London, surging wages in the city have been blamed for the growth of the housing bubble that started tounwind as liquidity tightened and cheap loans started to dry up. Rogoff suggests that, since wages are more rigid on the downside, it is possible that inflation can be used to erode real incomes and through that alter the prices of goods.

“It is helpful for central banks to target positive rates of inflation that “grease the wheels” of the economy by helping facilitate relative price adjustments, he says. “With positive inflation, an individual worker’s wage can fall in real terms without falling in nominal terms.”

The latest GDP growth figures for the second quarter of the year have come out in the Fed’s favour. Initial estimates had suggested that American GDP growth would be about 1.9% year-on-year but analysts were pleasantly surprised as the figure was revised upwards to 3.3%.

This stands in sharp contrast to Britain, which saw its GDP growth figures revised downwards by the Organisation for Economic Cooperation and Development (OECD). According to the developed countries’ economic club the British economy had zero growth in the second quarter and was likely to contract in the third and fourth quarter by 0.3% and 0.4% respectively. This would fulfil the commonly used definition of recession as two consecutive quarters of negative growth, and bring down predicted year-on-year growth for the whole of 2008 to 1.2%.

The eurozone has fared little better with the economy shrinking by 0.2% in the second quarter. Fears have now been expressed that the eurozone might also be entering a recession, despite its economy remaining relatively buoyant in the first quarter.

The figures suggest that the credit crunch has taken longer to take hold across the Atlantic, which may be a direct consequence of a relative lack of action by the central banks.

Although initially applauded for its swift extension of lending facilities and injections of liquidity into the market the ECB’s quarter point interest rate rise has been seen as a consequence of the differing demands placed on it by the 15 member countries it represents and its single inflation combating mandate.

“By now the eurozone should be looking to lower interest rates but they need to see inflation peak,” says Stein. “If they’d had a dual mandate they probably wouldn’t have raised rates in July and might have cut rates in 2008 rather than 2009.”

Mervyn King, the governor of the Bank of England, has also come under fire for a failure to act decisively and proactively to shore up the ailing British economy. His job has been made all the harder by statements from the chancellor suggesting that Britain is facing “the worst economic conditions in 60 years” driving shaky market sentiment even further down.

Ian Kernohan, an economist at Royal London Asset Management, says the story of the first half of the year was chaos in the American market but the story for the second half is likely to be the rest of the world catching up.

“The most interesting story has been the speed of the deterioration outside the US over the past six months,” he says. “What we’re looking at is simultaneous recessions in the US, the UK and the eurozone and perhaps elsewhere as well.”

With crude oil prices falling from a peak of $147 in July to $108 following the relative lack of disruption to output caused by Hurricane Gustav and the decision to release 250,000 barrels from the American emergency reserve the ECB and Bank of England may have scope to cut rates. The combination of economic weakness and falling commodity prices should cause a fall-off in inflation and untie the hands of both King and Jean-Claude Trichet, the president of the ECB.

Consensus suggests that King will drop interest rates before the end of the year with some economists predicting they could fall as low as 3.5% by the end of 2009. Few, however, are predicting an imminent change in the Fed’s target rate as the central bank will likely look to avoid any negative shocks to the market caused by raising rates.

Even if the policy of prioritising growth pays off in the short term doubts will still linger as to what the possible consequences of Fed action will be for the longer-term outlook for the American economy.

Stein remains convinced that the drastic nature of the action taken has been a case of too much, too early and has not been enough to remove the fundamental problem of lack of liquidity in the market.

“Willingness to lend and willingness to borrow are more important than interest rates,” he says. “The Fed has shot all of its ammunition and none of this has helped, so the Fed in a sense has made things worse.”

Buiter goes even further and says the Fed’s decision to drop interest rates and bail out struggling financial firms, such as Bear Stearns, has created a moral hazard by implicitly allowing large companies to think that the bank is underwriting risk. This will not only allow but perhaps even encourage the crisis to occur again as firms feel themselves too big to fail.

Their opinions are not shared by Batty who says that in acting to protect the system early the Fed avoided the worst-case scenarios voiced by some bearish market commentators in the early months of the credit crisis.

“The Fed haven’t had to target inflation as much as the Bank of England and the ECB have. I think it will be proved in the future that the Fed were right to be proactive,” says Batty.

“If they hadn’t done anything [to bail out Bear Stearns] there would have been massive systematic risk. By letting the banks down slowly they have helped to lessen that effect.”

The crisis that began in August, 2007 is not nearing its death throes yet. Whether the situation facing the global economy is unique, the responses to it have been. How successful the strategies have been is yet to be seen. Meanwhile, the general feeling echoes Cecchetti’s conclusion: “Let’s just hope they work.” l

The three governors

Mervyn King is governor of the Bank of England and is chairman of the Monetary Policy Committee. He was previously deputy governor from 1998 to 2003, and chief economist and executive director from 1991. King was a non-executive director of the Bank from 1990 to 1991. He studied at King’s College, Cambridge, and Harvard (as a Kennedy Scholar) and taught at Cambridge and Birmingham universities before spells as visiting professor at both Harvard and the Massachusetts Institute of Technology. From October 1984 he was professor of economics at the London School of Economics, where he founded the financial markets group.

Ben Bernanke was sworn in on February 1, 2006, as chairman and a member of the board of governors of the Federal Reserve System. Bernanke also serves as chairman of the Federal Open Market Committee, the system’s main monetary policymaking body. He was appointed as a member of the board to a full 14-year term, which expires on January 31, 2020, and to a four-year term as chairman, which expires on January 31, 2010. Before his appointment as chairman, Bernanke was chairman of the President’s Council of Economic Advisers, from June 2005 to January 2006.

Jean-Claude Trichet was elected chairman of the Group of Ten (G10) Governors on June 29, 2003. He was appointed president of the European Central Bank on October 16, 2003 by common accord of the governments of the member states for a term of office of eight years starting on November 1, 2003. He was chairman of the European Monetary Committee from 1992 until his appointment as Governor of the Banque de France in 1993. He was the chairman of the Monetary Policy Council of the Banque de France as of 1994, a member of the council of the European Monetary Institute from 1994 to 1998 and thereafter a member of the governing council of the European Central Bank. At the end of his first term as governor of the Banque de France, he was reappointed for a second term.