Get used to 4% - Lessons from the Credit Crunch

Among the forecasters, we were among the most cautious about further ECB interest rate rises. Our last ECB Watch, headlined “Could interest rates stay at 4% for the rest of the year” seemed extravagant at the time, and is now part of the new ECB-watch consensus that has been emerging in recent days. There is little chance now of a rate rise in September. Our argument was that the ECB would either be stopped by an appreciation in the euro’s exchange rate, or by market turmoil It turned out to be the latter. Of course, if the market turmoil had not started until October, the rate rise would have almost certainly have happened. Our call was lucky.

 

But as things stand now, the argument in favour of wait-and-see are overwhelming. First, we do not know how extensive the credit crisis is going to be. This is not fundamentally a subprime crisis, but a credit market bust. Nor is this a US crisis, but a global one. So far, financial institutions in the US and Germany seem to be the most affected. There is already news of some problems in China. From our understanding, Chinese banks have taken on more subprime CDO debt than anybody else, so we would expect some serious turbulance to arise there. A credit market crunch does not play out in a couple of weeks. This crisis will take months, if not much longer, to unwind.

 

Second, the credit crisis may affect the demand for money. We may soon see a sharp fall in M3 and bank credit, both of which would justify some caution on the part of the central banks. So far, this crisis seems to be confined to the financial sector. The rest of the corporate sector remains in a relatively healthy state. Balance sheets are relatively strong. As long as this contagion remains confined, the effect on the real economy is limited. Otherwise, the next rate change is almost certainly going to be downwards.

 

Third, there are signs of a mild economic slowdown in the euro area. The latest manufacturing and service data show a much softer economic environment. No signs of a crisis, but it is clear that the euro area has gone past the peak of the cylce. We are clearly in the downphase.

 

The hawks rightly argue that price pressures remain in the system. The price increases of wheat, which are about to lead to higher bread prices in France. Other commodity price hikes will also translate in higher consumer prices. This means that the ECB is going to be extremely cautious on the way down. While we believe that interest rates may indeed have peaked at 4%, we do not think that they are going to trough at 2%, or even 3%. This short-term interest corridor is going to be much narrower in this cycle than in the last.

 

The latter is also one of the most important lessons from the current credit boom and crunch. As Tito Boeri and Luigi Guiso have argued, this crisis is too a large extent produced by a monetary policy that used to be far too lax, in particular in the US. This crisis is largely Alan Greenspan’s legacy. Whatever may happen in the US – we assume that Beranke is ultimately going to be as irresponsible as his predecessor – the Europeans will this time not follow the largely discredited Fed. While we were doveish when interest rates were rising, we are extremely hawkish as interest rates are falling. With inflation running at current levels, we do not see much if any room for manoeuvre for rate cuts. Interest rates may hover at the 4% level for a long time, just as they hover at 2% after the economic downturn.

 

For us, the following are the most important policy lessons: monetary policy should be geared towards maintaining a high degree of monetary and financial stability. Abandon direct inflation targeting, move towards a broader base, which should include an analysis of monetary and credit conditions.

 

Second, do not bail out every bank. Some actors need to be penalised, otherwise we are going to see a re-run of the present crisis very shortly. In particular, central banks should not accept CDO tranches as collateral, as the Fed has just done. The argument in favour of extending the collateral base is insane. It rewards those who took on the highest risks. The lack of buyers in the CDO market is not irrational, as some bankers now claim. The fact is that much of this sometimes AAA-rated paper is largely worthless. What we have been observing in recent month is a return to normal levels of activity in the credit market.

 

Third, regulate global credit flows, including hedge funds. Evaluate the different proposals. Self-regulation should not be ruled out. A global credit register is an idea worth studying. We suspect that the cavalier attitude of the US and the UK regarding hedge fund regulation will probably change once this crisis escalates.

 

Forth, consolidate the European banking sector. It is no accident that the first banks to hit the rocks were German publicly owned banks. As these banks enjoy effective protection against default, their staff are taking on unnecessary risks. Furthermore, the management of Germany’s Landesbanken is appalling. There is a clear need to consolidate, and an equally clear need to do so at a European level.

 

There is enough to do. Most of this is not orginal. What we are proposing is little more than a return to time-honoured central banking practices. Our hunch is that this credit crisis is going to be more severe than presently discounted in the markets, and that the ECB is going to be more cautious, in both directions, and rightly so.

 

 

Eurointelligence ECB Watch

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