Federal Reserve & Interest Rates

The Federal Reserve along with the leading central banks of the world announced plans to add liquidity to dollar markets around the globe.  Another key initiative is the plan to re-capitalize the global banking system in exchange for ownership stakes in the financial institutions.

The BoE, ECB, and SNB will conduct tenders of U.S. dollar funding at 7-day, 28-day, and 84-day maturities at fixed interest rates for full allotment. Funds will be provided at a fixed interest rate, set in advance of each operation. Counterparties in these operations will be able to borrow any amount they wish against the appropriate collateral in each jurisdiction. Accordingly, sizes of the reciprocal currency arrangements (swap lines) between the Federal Reserve and the BoE, the ECB, and the SNB will be increased to accommodate whatever quantity of U.S. dollar funding is demanded. The Bank of Japan will be considering the introduction of similar measures. 

The partial nationalization of the world’s banking system may be the step that finally instills confidence in a system that has been without it for a number of months.  Sadly it seems that only governments actually have enough monetary resources to steer the world clear of the looming financial disaster.

The Treasury has announced that about $250 billion of the $700 billion bailout package will be invested to the nation’s banks and will provide cash injection in exchange for equity.  Last week the Bank of England announced a similar move to nationalize it’s banking system and other central banks are quickly following suit.

This will hopefully restart lending worldwide and unfreeze the credit system that has been locked up for months.  Stock markets around the world have already shown their approval with record rallies but it big question is will it last this time.

For too long the nation’s financial system has been irresponsible with it massive risk taking but whether or not things will change now that the government is involved remains to be seen.  Ironically it is the current lack of risk taking that has caused the current credit crisis with the banking system hoarding capital and unwilling to lend to even people with good credit.

In a move that underscores how serious the current financial crisis is effecting the global economy, the leading central banks of the world joined together in a coordinated monetary policy initiative.  The unprecedented joint effort to cut interest rates by half a percent was soon followed by other central banks as economies around the world attempt to stop the bleeding from the worst financial crisis since the Great Depression.

Inflationary pressures have started to moderate in a number of countries, partly reflecting a marked decline in energy and other commodity prices. Inflation expectations are diminishing and remain anchored to price stability. The recent intensification of the financial crisis has augmented the downside risks to growth and thus has diminished further the upside risks to price stability. 

Some easing of global monetary conditions is therefore warranted. Accordingly, the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, Sveriges Riksbank, and the Swiss National Bank are today announcing reductions in policy interest rates. The Bank of Japan expresses its strong support of these policy actions.

The European Central Bank up until now had been steadfast in their resolve in avoiding interest rate cuts in an effort to promote price stability.  The recent slide in oil that has accompanied the renewed strength in the dollar has played a large part in their reversal of course.

Global stock markets have taken a pounding in the last week with a number of exchanges halting trading.  At this point a global recession seems unavoidable.  Although the U.S. has avoided negative economic growth thus far, other countries haven’t been so lucky as the financial troubles in this country have quickly spread around the globe.

The $700 billion financial rescue package approved by Congress will take time to work it’s way through the banking system but until that happens credit markets will remain practically frozen.  Until lending can resume at normal levels, the housing market is unlikely to improve anytime soon.

The latest setback for Wall Street has also had a big impact on consumer confidence levels and we can expect Americans to tighten their belts further.  Consumer spending levels are expected to take a sharp hit during the holiday shopping season with many retailers cutting their earnings forecasts for the fourth quarter.

Whether or not this latest move by world’s central banks can stem the tide of financial collapse remains to be seen but the rest of the world is starting to realize that they are going to have to work together in order to get through this mess.

The financial system has been choked off by a lack of liquidity in the form of mortgage assets that no one wants to buy.  Treasury Secretary Henry Paulson has brought forth a plan for the government to become a buyer of last resort.

These illiquid assets are clogging up our financial system, and undermining the strength of our otherwise sound financial institutions. As a result, Americans’ personal savings are threatened, and the ability of consumers and businesses to borrow and finance spending, investment, and job creation has been disrupted.

The federal government must implement a program to remove these illiquid assets that are weighing down our financial institutions and threatening our economy. This troubled asset relief program must be properly designed and sufficiently large to have maximum impact, while including features that protect the taxpayer to the maximum extent possible.

The plan would be an unprecedented bailout of the financial system that is estimated at a whopping $800 billion.  I think the government finally realizes that monetary policy can only do so much on it’s own and that a fiscal plan was also needed to head off financial disaster.

The problems of the financial services industry is slowly getting worse, this week saw three financial giants brought low.  The Fed had to issue an emergency $85 billion loan to AIG to keep it from a disorderly collapse, while in investment banking, Lehman Brothers declared bankruptcy while Merrill Lynch sold itself to Bank of America at a fraction of it’s former value.

The banking system is clearly in big trouble and I’m not sure if the Federal Deposit Insurance Corporation has enough reserves to insure the deposits of Americans from the growing number of banks that are in danger of failing.  Credit is being choked off at the source as banks are stuck with assets that they are unable to sell.

Financial institutions raised hundreds of billions of capital to deal with writedowns from the subprime collapse but they are loathe to loan that money out.  The big problem is that the financial sector is so intertwined these day that even relatively strong financial institutions are worried about counter party risk so they are hoarding capital to protect themselves for when their weaker brethren start to fail.

This plan definitely puts taxpayer dollars at risk but the alternative could very well be a financial Armageddon that could plunge the world into another Great Depression.