After almost six months of credit difficulties, central banks are no closer to stabilizing financial markets. If proof were needed, today's FT Alphaville was full of half-baked and shocking rumours about banks.
Here is just a selection of what was on offer to the credulous reader:
"No foreign travel for Bank of England senior staff over Easter, supposedly because a major UK clearing bank is in trouble".
"Swiss government is preparing a bailout of UBS".
"BNP has no interest in a merger with SocGen-BNP merger because of further as-yet uncovered problems".
On the face of it, none of these rumours appear to be true. Nevertheless, these days financial markets are willing to consider any crazy story. This tells us how bad things have become. With Bear Stearns going under in just four short days, and the Fed bringing rates down to just 2.25 percent, there is a growing sense that anything could be true. This only weakens the financial sector further, since banks are now vulnerable to any unsubstantiated rumour - a dangerous situation for any leveraged institution.
Why have things become so unstable? How did things get so bad? A large part of the blame must rest with the Fed. These sudden interest rate reductions seem disproportionate and only serve to increase the sense of distress and panic. If the banks are illiquid, the Fed could have injected liquidity while accepting good quality collateral, without turning real interest rates negative.
Contrast the erratic behaviour of the Fed with that of the ECB. The European banks are also deeply implicated in the sub prime mess. However, the ECB kept its nerve. It injected liquidity to Spanish and Irish banks, who are in housing market related trouble, yet at the same time, left rates consistent with keeping inflation under control.
Instead, the Fed cut rates dramatically, weakened the dollar, destabilized commodity markets, and provoked a rapid run up in oil prices. Understandably, inflation expectations are rising, while the risk of a recession has not diminished. As a consequence, their counter-inflationary credibility is rapidly dissipating.
Our own Bank of England seems to be in between these two poles. It has cut rates, but it has not followed the Fed's mad dash to zero. However, UK inflation remains stubbornly high and inflationary expectations are rising. Based on today's MPC minutes, the Bank's resolve does appear to be weak and it would surprise no one if they also succumbed to the Fed's moon-madness.
Above all, central banks need to be credible. That means that people need to believe that they have inflation under control and that they are ready to provide liquidity to cash-strapped but essentially solvent banks. Currently, the ECB comes closest to meeting this test. The Bank of England looks to be very shaky, while the Fed seem to have lost the plot altogether.