Credit Stress

While the US Fed reduced its funds rate by 75bp in March and there remains a serious risk that the Bank of England could ease in April already, the European Central Bank remains firmly on hold. All major central banks in the Western world have to deal with the fall-out from the financial turmoil, all face the risk that elevated oil and food prices could eventually spill over into higher inflation expectations and stronger wage claims. For the ECB, these inflation concerns still dominate amid falling unemployment and mounting wage claims. However, a further softening of Eurozone growth in the next few months could alleviate such concerns and still open the door for cautious ECB easing over the summer, especially if financial markets remain unsettled and the euro remains strong. In the US, the March rate cut highlights the Fed’s overriding near-term priority is to restore financial market order and limit the fallout of financial stresses on economic performance. We continue to expect the funds rate to reach 1.5% by June. However, elevated concerns about inflation, highlighted by two official dissents from the aggressive 75bp move on 18 March, illustrate the dilemma facing the Fed. Eventually, the Fed will raise rates, but credit stresses likely will elongate the lags between monetary easing and accelerating aggregate demand, so any reversal in these Fed rate reductions are a ways off.

The  Fed

The Fed is playing the role of lender of last resort full tilt, enhancing the scope of its lending facilities, easing its Federal funds rate target below headline and core inflation, and even providing credit to a commercial bank to orchestrate an acquisition.  Not to be outdone, Ofheo loosened capital requirements for Fannie Mae and Freddie Mac, providing flexibility for them to add more mortgage securities to their bloated balance sheets.  Not surprisingly, volatility reigns in financial markets.  Meanwhile, economic performance continues to disappoint.