Monetary policies in times of turmoil

The current weakness in the US financial markets has recently been magnified overseas as panic spread to foreign investors with exposure to U.S. asset backed debt. The recent sell off in global stocks was in general liquidity-driven and a consequence of mispriced risks in the US sub-prime, derivatives and international currency markets. Initially many investors, particularly those using leverage, were forced to meet margin calls by selling assets to raise cash. Since the assets causing the problems had little, if any, value, they were forced to sell other assets instead, causing prices to fall sharply. In addition, the increased risk aversion that followed led to de-leveraging of other speculative positions like for instance the yen carry trades; speculative-grade corporate bond issuance ground to a halt; and the asset-backed commercial paper market seized up, even for high-quality investors.

Investors started to pull large amounts of money out of risky investments, including some hedge funds. American, European and Japanese banks became wary about lending each other money. Stock markets took a sharp dive. Even high quality issuers and borrowers had to scale down their demand for new capital and had to accept less favourable issue prices.

But one has to keeping mind that the steep drops in many stock valuations in Europe, Asia and Australia do not stem from financial distress in the companies themselves, but simply from the short-term distress of their highly leveraged shareholders, creditors and several financial institutions acting as intermediaries.

MARKET INTEREST RATES AT PRESENT NO GOOD FINANCIAL COMPASS

Traders and policymakers alike believe that the interest rate futures market is being used by investors to hedge positions taken in other markets. As government bonds are temporary in demand as safe haven securities, the present market interest rates nor the prices of futures can be used to predict the future path of US interest rates.
One might derive some conclusions from the policies of the Federal Reserve. The continued Federal Reserve’s strategy of increasing liquidity and pursuing only a half-point cut in its discount rate, rather than resorting to a cut in the benchmark interest rate seemed successful.
Its policymakers are probably still busy making their estimates of what the turmoil means for the US economy. Most likely they will see the impact as being mostly one of increased downside risks to growth, with smaller revisions to the base case forecast for growth. In that scenario the tightening of credit conditions will push the Fed Reserve to ease by no more than between a quarter point and a half point this year, to leave overall financial conditions as they were before the turmoil began. More radical scenarios are available however, tending to assume that the Fed will have to take additional action to unblock the financial system, and prevent more extreme spillovers to the economy.

CENTRAL BANK MONETARY POLICIES ON HOLD

Much depends on how long the market turmoil continues a judgment monetary authorities have no great informational advantage in making. In any case the pressure for supplying additional liquidity will probably continue for several weeks and even some months as the backlog of redemption requests has to be cleared and likewise the solving of problems of financial institutions in distress. The processes of repricing of credit and of deleveraging are ongoing. The uncertainties of a more sound pricing of risks have to be reduced significantly before demand for assets with amore risky nature will resume. As bank debt securitisation has meanwhile been dealt a body blow many of these institutions have to put their house in order and have to maintain tight credit policies.

The monetary policies of the European Central Bank, the Bank of England and the Bank of Japan have probably gone on hold for the time being, no longer raising their interest rates but not cutting them either, content to see whether the Fed succeeds in calming global markets. The only thing the ECB did was to call for a 91-day refinancing tender, and reiterating its monetary policy stance was the same as that expressed on Aug 2 of this year.

The central banks will probably remain flexible in their thinking. But they cannot afford to ignore what the market is pricing in, even if this is distorted by hedging.
It now looks like the central bank interventions will probably succeed in calming global financial markets, arresting spreading fear and restoring the healthy functioning of credit markets.

Drs. Alphons P. Ranner is founder and director of Sovereign BV financial consultancy. His background includes many years of experience in strategic and financial management and consulting.

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