Fed Rate Cut May Not Be Solution To Market Woes

The economic and financial argument for a US Federal Reserve rate cut at this stage may well be getting stronger.

But, not everyone is convinced that lower rates will provide the solution to the current turbulence in global financial markets. "A rate cut could be an ill-suited policy tool," said Michael Carey, a senior currency strategist at Calyon Credit Agricole in New York. "Talk of emergency target rate reductions - in the US or elsewhere - is premature," agreed Steve Pearson, senior currency strategist at HBOS in London. He argued that although one or more financial institutions may be on the brink of bankruptcy, "in general terms the current liquidity squeeze and associated waves of position liquidation are more a threat to profitability than capitalization." As such, he reckons that central banks will continue to merely add liquidity rather than resort to lower rates. Friday, the Fed illustrated just how close it is to considering a rate cut by lowering the discount rate 50 basis points. This is the rate at which banks can borrow from the Fed when they run out of credit in the interbank market. This certainly injected a little more stability, but it's the reduction in the more general Fed funds that many in the market are looking for. Calyon's Carey suggested that even if a cut in Fed funds does come, it would fail to ease the liquidity problem given that lenders still won't lend even then. "Lenders are extremely wary about lending money, even overnight, afraid the borrower has some horrible exposure and won't be able to pay back as planned," he said. "How would a Fed rate cut help to alleviate this fear?" Carey asked. "Unless the Fed can provide the markets with information that will help them get a handle on the magnitude and the owners of the subprime paper, cutting the Fed funds by 50 or even 75 or 100 basis points may be of limited help - the proverbial "'pushing on a string'," Carey added. Nevertheless, this hasn't stopped a chorus of calls from across financial markets for the Fed to stop sticking on rates before an even more serious crisis develops. "The alternative to lower interest rates and money relaxation is a prolonged financial market correction if not a market crash," warned Hans Redeker, head of global foreign exchange strategy at BNP Paribas in London. Andy Chaytor, rates strategist at The Royal bank of Scotland in London, reckons that the longer the Fed waits, the deeper it may have to cut. He said if cuts get pushed into the future, "the pricing of the depths of the cuts becomes deeper owing to the belief that the longer it's left the deeper the growth slow down."

Subprime Problems Might Take Toll On Broader Economy

Certainly, the Fed has made it clear up to now that policy shifts will be dictated by the economy, not the market turbulence. And this is where some reckon that the rot has already started to set in. This week, the Philadelphia Fed and the Empire State surveys showed a disappointing decline in activity at the same time that housing figures suggested that the problems of the subprime mortgage market have much further to run. In July, housing starts fell 6.1% on the month, taking them to their lowest since January 1997, with building permits falling to their lowest level since October 1996. "We believe the correction has much further to run, keeping financial markets under pressure for longer," said Dimitry Fleming, an economist at ING Financial Markets in Amsterdam. The latest University of Michigan consumer confidence survey Friday only contributed to the impression that the subprime problems might be starting to take its toll on the wider US economy. The data, which is the first to cover the period of turbulence, was expected to ease to 88.0 from 90.4. In the event the main sentiment index fell to 83.3 - its lowest level in more than a year. As HBOS's Pearson noted, consumer confidence "is under assault from falling asset prices." However, BNP Paribas' Redeker feels that fears of a credit crunch have already tightened policy. He suggested that the sell-off has reduced global wealth by as much as 6% and has reduced liquidity due to rising volatility and investors taking cash off the table. "Consequently, monetary conditions have tightened due to recent events and if not countered by lower officials rates, this would put an additional burden on the economy," Redeker warned. "Aggressive rate cuts would put banks into the position of taking risky assets back onto its balance sheets, thus solving the crisis," he added. In early trading Monday, major currencies were generally still around the levels they reached after the Fed threw the market a lifeline Friday. The euro was at $1.3494, flat to levels late in New York Friday, according to EBS. It was also at Y154.81 from Y154.07. The dollar was at Y114.72 from around Y114.40. Sterling was at $1.9830, little changed from late Friday.