The FOMC decided on 18 September to lower the target Fed Funds rate by 50 base points to 4.75%. This rate cut, which will not be the last one, can hardly be criticised as to its substance.
Indeed, the issue is no longer whether such a decision worsens or not the risk of moral hazard by bailing out players who have taken excessive risks. In fact, this is one of the key reasons of the current crisis. However, this is not what matters the most. The real economy has been definitely hurt. Its fragility had already become significant before the subprime crisis broke out, even though many commentators, impressed by the rebound in growth in the 2nd quarter, claimed — in contradiction with cyclical indicators — that the worst was over.
For instance, at the beginning of the summer, although growth had remained under its potential rate since the spring of 2006, FOMC members were focusing their attention on inflation. Core PCE, a gauge of underlying inflation, which the Fed monitored more closely than other indicators, had slowed down but continued to remain in the upper range of the Fed’s well-known “comfort zone” (1-2%). Was this enough to warrant launching a monetary easing? Would it not be better to wait and see whether this deceleration in inflation was confirmed by underlying inflation heading back towards the middle of the range? There was also a debate about whether referring to underlying inflation was the right choice: the items ruled out when calculating it (food and energy) no longer seem to be white noise but look like factors leading to a long-run increase. Unsurprisingly, these debates were rapidly forgotten once the financial crisis broke out.
Finally, there was growing awareness of the fact that the real estate correction, after cutting
growth by around 0.8 percentage point in the last 6 quarters, was far from over. Already, the consequences of the levelling off in home sales and the ballooning unsold house inventories on prices and activity in construction were clear to see at the start of the summer.
The subprime crisis worsened and the tightening in financial conditions spread to all credit segments — rates on prime loans rose 50 bp and jumbo loans by around 100 bp in August. This development had already been shown by the Fed’s February and July Senior Loan Officer Opinion survey. Reckless optimism gave way to a comeback to reality: the correction under way is far from over and prospects of an even sharper decline in price are taking shape.
The Fed feared the effects of a tight labour market. The “new conundrum”, which consisted in the fact that employment remained unscathed by the contraction in activity, vanished when job creation figures covering the last few months, i.e. 40,000 on average, or a four times slower pace than recorded in previous quarters. As a result, a hurdle in the way of rate cuts was lifted.
Already, cash extraction on the basis of real estate assets, after significantly fuelling consumption in the last few years, dried up as home prices stopped rising. Will the financial wealth effect, which might result from a bull stock market, effectively take over? Nothing is less certain insofar as the tightening in financial conditions might lead to a slowdown in share buybacks and, accordingly, lead to the disappearance of a factor boosting household wealth. The subprime sector itself, insofar as two-thirds of loans of this category entail rate resets — with typically a changeover from teaser rates to higher adjustable rates after two years — which will be massively implemented in the next three quarters, will drive repayment defaults upwards for this category of borrowers or, at the very least, result in an increase in interest expenses that will weigh on consumption.
Under these conditions, despite the good performance of company earnings, in all likelihood, the uncertainty about demand will result in a wait-and-see stance in terms of investment. The foregoing shows that the real economy had already been hit before the crisis broke out and is far from pulling out of its doldrums. It now seems to be in an even more vulnerable situation, as the challenge is now quite simply how to deal with risks of a recession given the worsening fragility the US economy currently faces. The relative weight of risks suggests that one should implement a risk management policy in line with the one conducted when deflation concerns appeared. There will always be enough time to tighten monetary fine-tuning when this is called for.
As one could expect after Jean-Claude Trichet’s conference speech on August 23 in Budapest when he had stressed the fact that ECB never pre-commits, the central bank did not rise its refi rate on September 6. In addition, Mr Trichet did not make any reference to his famous code words “strong vigilance”. In fact, an increase in rates would have been odd in a context where the crisis in the monetary market is persisting, and where the ECB has to inject massively liquidities in the market. Besides, even before the recent crisis burst, it was obvious that the economy had passed its peak, as testified by both the disappointing growth figures for Q2 (0.3% q/q) and the steady retrenchment of the business cycle indicators, such as the PMI, over the last few months before a marked drop in September, particularly in the services sector. All this suggest that GDP growth is very unlikely to outpace potential in the coming quarters. The latter are yet consistent with a moderate activity, in line with at best the potential.
The recent crisis goes much beyond the subprime issue, it comes with a wide reassessment of financing conditions, whose consequences exceed those which one could have expected of a rate hike in a normal environment. In other words, the market did the job even more than the ECB would have.
The ECB has adopted a “wait and see” mode. Will it increase rates once the turmoil in the money markets cools down?
There are no reasons for that. The US slowdown, together with the tightening in financing conditions will result in a moderation in growth in the eurozone. That should brush away the concerns regarding inflationary pressures related to the shrinking of spare capacity and bottlenecks in the labour market. The rate of inflation is presently in line with ECB’s target and is unlikely to rise.
One should not rush to conclusions regarding the evolution of the monetary aggregate M3 (+11.7% y/y in July) without examining the underlying forces. In fact, the past rate hikes have made the holding of cash balances more expensive. This is translated by the modest rise in M1, 6.9% y/y in July. The money acceleration comes from M3-M2 (+19.8% y/y). This is the result of an increased preference for liquidity. We have seen such an episode of liquidity preference at the beginning of the 2000’s. At that time, the ECB proved to be pragmatic by cutting rates despite the rapid increase in M3. The increase in credit aggregates also deserves to be qualified. Although the increase in loans to the corporate sector is dynamic -- 13.6% in July – mortgage lending has moderated very significantly over the past 12 months. Its expansion slowed from 11.4% y/y in July 2006 to 8.1% in July 2007.
It is likely that in the short term, the crisis in the financial market will lead companies to rely more on credit lines rather than on market funding. At a longer horizon, the tightening in monetary and financial conditions and the economic slowdown should have the opposite consequences on credit demand. If this outlook materialises, resumption in tightening would be most surprising to say the least.