Monday, 2 June 2008

A lesson from America

It is an often forgotten point, but central banks only control short term interest rates. All other rates are determined by the market.

In the US, the Federal Reserve are being reminded of that lesson right now. The Bank of England would do well to watch and learn.

In the wake of the credit crunch, the Fed reduced rates dramatically. However, all other rates remained stubbornly high. The Fed's frantic rate cuts might have prevented an immediate banking crisis, but it destabilized price expectation. Commodity prices shot up, the US dollar hit record lows against the Euro, and inflation is now rising. The focus on bank balance sheets has also eroded the Fed's counter inflationary credibility. Ideally, the Fed should raise rates, but it is unwilling to do so, and people are now beginning to expect a lot more inflation going forward.

These higher inflationary expectations are now feeding through into long-term interest rates. Last week, US mortgage rates soared amid a sharp rise in Treasury market yields. 30-year fixed-rate mortgages hit a three month high of 6.02 per cent. The previous week, rates were 5.81 per cent. Meanwhile, the "jumbo" mortgages – loans above $417,000 – rose to 7.21 per cent from 7.05 per cent. These market-driven interest rate hikes will only serve to exacerbate problems in the US housing market.

Over here in the UK, there is a to be learnt from the US experience. It points out the futility of cutting rates in the wake of rising inflationary pressure. The yield curve will soon twist upwards as inflationary expectations increase.

While the Bank of England avoided the mad dash to negative real rates, nevertheless, the MPC have kept rates far too low. Inflation is rising and the BoE seem reluctant to respond. Wage setters are beginning to pick up that the BoE are not serious about controlling inflation. If the MPC thinks that low rates will sustain growth, then the yield curve will confound them.


aSteve said...

Hey, we need some diagrams of funky yield curves (with historic comparisons) ;)

I think I grasp yield curves and their significance, but I suspect many readers will not.

It is interesting to note that commercial banks have been clamouring for the BoE to increase the term of its lending far more than they have clamoured for it to slash rates. Of course, this complicates matters... a single base-rate figure no-longer captures BoE policy adequately. It will, of course, be a very long time before the mainstream media pick up on this.

Ed H said...

I think the Fed wanted the curve to steepen A LOT because the Fed is more worried about banks than consumers. With the crisis and banks borrowing short and lending long, a steep yield curve is a very good thing.

The problem is LIBOR because LIBOR is not coming down so the interest rate spread for banks is not enough for them to get through this crisis over the long haul. This was the Feb prescription after the S&L crisis in the 1980s.

As The Verve once sang "The Drugs Won't Work"

Alice Cook said...

Ed H - during the S&L crisis this was what was known as the the "fat spread strategy" - cheap funding costs, high lending rates. It was a back door way of recapitalizing the banks by making the depositors pay.


Anonymous said...

I think I made this point above - central banks always have the same solution to a banking crisis: steepen the yield curve.

It doesn't work today because the US and UK are not closed systems.

The big brake on inflation is global wage arbitrage. Basically, the UK wage earner will be told "tough luck" when asking for a CoL rise. Now if only the government would do the same to the public sector......

On that note, I'd like to see a post on where you think public sector wages are headed. Here's what I take to be the main points:

- The government is broke;
- It is about to get even more broke;
- While they MIGHT be able to increase the debt burden, I wonder if anyone will buy it and at what rates;
- Huge cuts are coming: in jobs, hours, and salaries

The government has been propping up employment figures for a long time by creating worthless public sector jobs. Now that they can't afford it anymore (or more correctly, can't maintain the pretense that it ever could be afforded) the cuts will come.

And that's deflationary.


Russell said...

But in the UK lots of people have trackers on the base rate and hence the BOE can still lower their borrowing costs irrespective of what happens to LIBOR or gilt-rates. In this respect the UK mortgage market is different to euro area or the US.

Of course if LIBOR remains high then that becomes a problem for the banks as the business they have written as loans referenced to base rate become unprofitable, unless they have a high enough spread on top.

Ed H said...

thanks, that's the best term: "the fat spread" strategy. There's no way they can use this strategy enough right now because the writedowns are too large for the banks to make any money without de-leveraging first.

A high LIBOR makes "fat spreads" even more unlikely. As for the "closed system" that anonymous speaks of, that's not the real point here. If you can borrow cheap, you will. And nowhere can you borrow cheap because banks won't lend to one another.

Alice, your posts are great. Thanks for reminding us that what didn't work in the US won'twork in the UK either.

Ed H said...

I'll try and write a post on this too because the point Alice is making is important irrespective of whether you have a lend and carry model or a lend and securitize model: financial service firms borrow short and they can't make any money unless rates give them adequate spreads.

If inflation forces the BOE's hand, that's a problem. If the Fed/BOE doesn't raise rates inflation expectations become anchored and you have another problem.

Ed H said...

I left two related posts on my blog to further the conversation:

What's a central bank to do?"



comments are appreciated, including from Alice.

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