Weekend's Featured: Renewed Manipulation in Commodities

Commodities Are Being Manipulated Again Like in the Past?

In 1980, the Hunt brothers cornered the silver market, causing an epic price spike and then a bust. Crude oil is close to $130 a barrel. Is something similar at work? The US Congress suspects as much and held a hearing on market manipulation in Washington on Tuesday.

Long-term investors in the sector believe that the big institutions that have entered in recent years are "accidental Hunt brothers". Investment in indices based on commodity futures have risen from $13bn five years ago to $260bn now, according to Michael Masters, an investor who testified. The rise in investors' demand for oil futures is almost equal to the increase in demand from China.

Historically, futures markets are naturally short (betting on a fall) as producers tend to buy futures to guard against falls in prices. In 1990, only 13 per cent of open interest in crude oil futures was long. That is now up to 58 per cent - probably thanks to new investors.

Changes to indices have dramatic effects on prices. Crude oil briefly dipped below $50 early last year after a cut in the weighting towards energy in the GSCI index. And there is no shortage of commodities in the US - although many fear there are constraints elsewhere in the supply chain.

There are arguments against this. Big economic factors are at work, notably the weakness of the dollar. Federal Reserve officials note that there is no sign of big increases in inventories of commodities. This would be expected if speculators were betting on prices to rise. Thinly traded metals such as cobalt have also enjoyed sharp run-ups.

These cannot be attributed to speculators. Speculation appears to be changing the way commodity markets work. A debate is needed and changes to regulations may be justified. But speculators cannot take all the blame for the price spike.

Fed to Act if Inflation Turns Sour

US Federal Reserve is Ready to Act if Inflation Turns Worse Despite Pressure of Recession.

How stable are inflation expectations in the US? This is the key to understanding how far the Federal Reserve will be able to go in cutting interest rates to stave off recession. As this week's minutes show, the Fed views the latest inflation data as "disappointing". Inflation reached an annual rate of 4.3 per cent in January, with the underlying core rate at 2.5 per cent.

The central bank is willing to look past the inflation numbers and focus on fighting recession risk, in part because it believes that economic weakness will ultimately moderate price ­pressures. But there is a caveat. The Fed will tolerate higher inflation only as long as it believes this is not seeping into inflation expectations and fostering a 1970s-style inflationary psychology.

That is the real stagflation risk - not a few months of weak growth and relatively rapid price increases. As Fed governor Frederic Mishkin said in a recent speech: "The flexibility to act pre-emptively against a financial disruption presumes that inflation expectations are firmly anchored."

The awkward fact is that market-based measures of inflation expectations have been moving up for a while. Crude comparisons of the difference in yield between ordinary Treasury bonds and Treasury inflation-protected securities show little change.

But these measures do not take into account the jump in the liquidity risk premium since the start of the credit crisis, which increased the attractiveness of more liquid ordinary bonds. Adjusting for this, the Cleveland Fed calculates that the inflation rate the market expects to prevail over the next 10 years has risen sharply, from 2.3 per cent at the end of July last year to 3.2 per cent today.

Using a different approach, Macroeconomic Advisers estimates that the inflation rate expected to prevail over a five-year period starting five years from now has gone up from roughly 2.5 per cent last spring to 2.96 per cent today.

Some survey-based measures of inflation expectations have also edged up, although they remain much more ­stable than market-based measures. "Recent data on inflation expectations are not all that reassuring," says Stephen Cecchetti, a professor at Brandeis university.

The Fed minutes argue that the market-based measures may exaggerate the move-up in expected inflation. Changes in recent months "probably reflected at least in part increased uncertainty - inflation risk - rather than greater inflation expectations".

However, economists say this would still be worrying, as it implies that investors do not think inflation expectations are very firmly fixed. The minutes say these expectations remain "fairly well anchored". But Goldman Sachs detects a "persistent concern" about the need to monitor them.

Larry Meyer, chairman of Macroeconomic Advisers, says the move-up in market-based inflation expectations is "cautionary". He believes the rise to date would not prevent the Fed from cutting rates again in March. But a significant further increase - or an equivalent move up in the survey-based measures - would be hard for the central bank to stomach.

Bank of England Looks for Inflation Risk

Bank of England's MPC weighs on inflation risk in considering further interest rate cuts.

The Bank of England's monetary policy committee would be considering even deeper cuts in interest rates were it not for worrying signs that inflation is likely to spike soon and stay high this year, a key member of the committee said on Tuesday night.

In remarks about the economy that appeared even gloomier than those by Mervyn King, Bank governor, last week, Kate Barker warned that the benign economic conditions that have characterised the past decade are coming to an end. The risks, particularly the implications of weaker property prices for the banking sector, could easily justify further monetary stimulus, she said.

"My chief concern is the significant possibility of a large downside risk to growth, and therefore to inflation, as the impact of the credit tightening works through the economy," Ms Barker said in a speech to the North Staffordshire Chamber of Commerce and Industry in Stoke-onTrent. "I rate this a little higher than a large upside risk to inflation over the medium term from dislodging inflation expectations on the upside."

Banks' difficulties in accessing wholesale funds could prompt them to cut back on mortgage lending in 2008. "In this case, the mortgage market could become less competitive and more expensive, feeding back into a decline in the housing market, somewhat lower consumer spending, and also into lenders' balance sheets, reducing lending capacity further."

Ms Barker is seen as neither a dove nor a hawk on rate decisions and most often votes with the majority. However, in a tacit acknowledgement of just how rapidly new data are altering the overall picture of the economy, Ms Barker appeared to concede that even the latest figures may already be out of date.

She signalled that the MPC was prepared to take a pragmatic approach to rate-setting. "Judgments about the correct policy response may need to be unusually flexible with much more uncertainty than normal around the future path of policy rates," she said.

However, she reinforced the message from Mr King last week that there is a real and immediate concern about a spike in inflation which, although probably of external origin, may seep into the expectations of consumers and workers.

Weekend's Featured: Austrian Hills are Alive in the Alps

Austria is now becoming the alternative as one of dream property targets in the Alps.

Fed up with France; irritated by Italy; squeezed out of Switzerland? Austria is now the alternative for foreigners seeking their dream property in the Alps. That, at least, is the message from estate agents scouring Europe for something fresh and affordable that doesn't require backpacking to Bulgaria or a pilgrimage to the Pyrenees.

For European skiers, Austria is familiar ground. Britons on charter flights, Dutch in private cars and Germans in their busloads are well accustomed to the Tyrol and beyond, attracted by the fair prices, agreeable family skiing and general cosiness that have for years distinguished Austria from France or Switzerland.

Admittedly, some resorts, such as Lech and Kitzbühel, are every bit as glitzy as Courchevel. But, generally speaking, Austria's reputation rests on smaller, less glamorous towns and villages from Alpbach to Zell am See that have earned loyal followings for those looking to ski in friendly surroundings without breaking the bank.

Visitors interested in establishing a more permanent presence via a second home, however, are likely to encounter a less accommodating reception. In spite of the fact that Austria has been in the European Union since the mid-1990s, rules on holiday homes are almost as complex and restrictive as those of the neighbouring Swiss.

Like Switzerland, Austria has a federal system that devolves much power from the central government in Vienna to the nine federal states. Although not as extreme as Switzerland, the states themselves pass on significant powers to individual towns and villages. Policy on planning and home ownership is very much a local affair.

As in other countries, elaborate zoning rules apportion land to specific uses, whether it's residential, commercial or farming. But in Austria's best known tourist regions and especially its most famous mountain resorts, the allocation for second homes is virtually nil.

For years such severe restrictions meant most developers and agents had given up on Austria for holiday homes. But recently improved transport links have prompted some to take another look, with Salzburg province in the foreground.

Although far less famous for its skiing than for the culture of its famous capital, Salzburg has much to offer in winter sports. Schladming is a popular family resort on most tour operators' lists. Obertauern, less developed but lying much higher, is as busy. Smaller areas, such as Filzmoos, Annaberg, or the three valleys linking Flachau, Wagrain and St Johann im Pongau, fill out the picture.

Greatly improved access has raised the region's profile for foreigners. Salzburg always had good road and rail links, particularly via its sometimes notoriously congested motorway to Munich and points north. But the arrival of budget airlines has transformed its once sleepy airport, leading to improved international connections. Much of the skiing is within an hour's drive.

What has made Salzburg particularly interesting for property is the availability of homes. The rules remain tough. A holiday flat or chalet comes in two legal categories: either with no strings attached - the bare minority - or subject to mandatory renting requirements to third parties for much of the year.

The aim is to avoid so-called "cold beds". The Austrian response of forcing owners to make their properties available for rental, while draconian, is being examined more closely elsewhere. Agents argue the rule is not such an imposition. "Many owners want to rent out their places anyway to help cover the mortgage and running costs," says Simon Malster of estate agency Investors in Property. "And that ensures someone is keeping an eye on their places in their absence."

The modalities differ depending on the deal struck between developer and local authority. Some require rental through a tour operator; others leave it up to owners to find a local agent, offering more control and even enabling owners to rent to themselves for additional weeks, strange as that sounds. "It is controlled. But it depends on where you are and the attitude of the local council to development", says Thomas Schatzl, a Salzburg province notary.

At Alpendorf village, a group of chalets above Annaberg in the Dachstein West ski area, owners are obliged to rent out through a Netherlands-based tour operator. While that might seem an imposition, the development is both attractive and astonishingly good value compared with similar schemes in France or Switzerland. Under the deal, owners have exclusive use for four weeks each year - probably more than enough for most - and can stay longer for a fee.

Scattered around a steep hillside and virtually on the piste, the project, now 80 per cent completed, offers two- and three-bedroom chalets of about 90 sq metres at EU225,000-EU250,000, excluding value added tax, which can be reclaimed. The complex includes a clubhouse with reception, bar and restaurant, and an attractive indoor pool. "It's what you'd pay for two garages in Switzerland," jokes Malster.

This year's conventionally cold winter has left plenty of snow on the ground, even though Alpendorf lies under 1,000 metres and the highest point in the entire ski region is only about 2,100 metres above sea level.

Those wanting greater snow security could try Obertauern, the purpose-built resort at the top of the Tauern pass, situated at about 1,700 metres altitude. Attractive, if somewhat artificial, Obertauern lacks a real centre but the atmosphere is pleasant and the skiing is extensive, with 26 lifts and about 160km of pistes. The resort's snow record is one of the best in the Alps.

On the village outskirts, heading north to Salzburg, Savills Alpine Homes is marketing a new development of ski-in, ski-out flats called the Zehnerkar Mountain Resort. An initial phase, comprising 11 apartments, has been completed and is now renting as holiday flats. The similar sized second phase, due for completion by December, has been fully reserved, meaning attention is now focused on the much more ambitious phase III, with three stepped buildings in chalet style.

Guy Taylor, a British architect, has teamed up with Michael Ellmer, the local developer, to move Phase III upmarket. The new apartments, priced between EU199,000 for one bedroom and EU550,000 for a three-bedroom luxury penthouse, promise finishes to the highest standards and integral fitness and spa facilities. Better still, there is no obligation to rent out the properties.

Admittedly, few of the Austrian locations now coming to the market can match established Swiss, or even French resorts, in terms of prestige or range of skiing. But with keen prices, good workmanship and improved accessibility, Austria looks set to move up the ski property league.

ECB Meeting to Prepare for Balancing Act

Next week's ECB policy meeting is likely to prepare for delicate balancing act.

The level of attention that next week's European Central Bank policy meeting is likely to attract might seem strange given that not one of 83 economists polled by Reuters expects any change to interest rates.

But these are unusual times for central bankers and financial markets, and investors will hang on every word uttered by ECB president Jean-Claude Trichet at the post-meeting press conference. The reason lies in the strong polarisation between the market's view on rates and that of the ECB itself.

Bond yields are pricing in rate cuts from the current 4 per cent in the months to come. But Mr Trichet remains unswervingly committed to fighting inflation, in spite of expectations that eurozone growth is set to slow in tandem with the rest of the global economy. European rates have been held at 4 per cent since last June, even though the US Fed Funds rate has fallen sharply from 5.25 per cent to 3 per cent since September.

A welter of data releases this week highlighted the ECB's dilemma. The "flash" estimate of consumer prices showed that the annual rate of eurozone inflation climbed to 3.2 per cent in January - the highest level since the data series started in 1997 and the fifth successive month that inflation has come in above the ECB's 2 per cent price stability target.

Although a breakdown of the figures is unavailable, it would appear that rising food and energy prices more than offset the dropping-out from the annual comparison of Germany's 3 per cent VAT increase implemented last January.

That view is backed up by an extremely modest decline in German headline inflation rate this month. "If you take into account what should have been significant favourable base effects from last year's VAT hike, the stubbornly high rate of inflation starts to look much more worrying," says Jennifer McKeown at Capital Economics.

Of paramount concern to the ECB will be the risk of second-round inflation effects - particularly given that the eurozone unemployment rate held at a record low of 7.2 per cent in December. The annual 11 per cent wage increase recently secured by German rail workers will no doubt have set alarm bells ringing at the ECB.

But at the same time, overall economic sentiment in the eurozone dipped to its lowest for two years, while consumer confidence - affected by the recent turbulence in financial markets - fell to its worst level since November 2005. And while there was a modest increase in eurozone manufacturing activity last month, there are few analysts who do not expect to see a sharp slowdown in the region's growth as the year wears on.

Indeed, the International Monetary Fund this week slashed its forecast for 2008 growth in the region by half a percentage point to 1.6 per cent. UBS went even further, lowering its forecast to 1.3 per cent. "The bottom line is that we think economic conditions have to get a lot worse before they get better, and that the euro area will feel the fallout from the US recession," says UBS economist Stephane Deo: "Despite our very cautious numbers, we believe the risks to our scenario are still on the downside."

David Brown, chief European economist at Bear Stearns, warns that the European economy is assuming a mantle of stagflation. "Growth momentum is slipping quite sharply while inflation expectations remain on the rise," he says. "The ECB needs to bear in mind that stagflation does not mean the priority must be with inflation. If the dangers to growth are rising, it means that its commitment to counter-cyclical stimulation becomes much more important."

The forthcoming European earnings season might also make for some uncomfortable reading for the ECB. Goldman Sachs thinks the consensus expectation for 10 per cent European earnings growth this year is far too high.

"Our top-down model suggests European profits will fall by 8 per cent this year as the US enters a recession, global growth slows and high costs begin to erode corporate profitability in the face of slowing revenues," says strategist Georgina Taylor. "We also expect a decline in profit margins - consensus continues to expect margin expansion across the majority of sectors."

For all that, one could be forgiven for thinking that the next rate move could be upwards given recent comments from ECB board members. For example, the head of the Greek central bank has stressed that if there was a risk the ECB would not achieve its inflation objective in the medium-term, it would be prepared to act decisively and pre-emptively.

Such remarks add weight to the view that the ECB is walking a very tricky policy tightrope at the moment. As Mr Brown at Bear Stearns notes: "The price that the ECB paid for delaying the easing cycle in 2001 was a German recession and interest rates ultimately had to come down to 2 per cent."

Economic Evolution Would Tell Whether Fed Is in Panic

The evolution of economy in the world would determine whether the Federal Reserve overreacted in its decisions.

Monday was a holiday in the US - Martin Luther King day. But Ben Bernanke was in the chairman's office at the Federal Reserve, working through the holiday as he often does.

On his desk his Bloomberg, Reuters and Dow Jones terminals flashed red as selling in global equity markets spread from Asia to Europe. The US markets were closed, but US stock futures were still trading, and they too started to plunge. When US markets reopened on Tuesday it looked as though there would be a bloodbath.

For the chairman it was decision time. Mr Bernanke had already resolved the US central bank needed to make a radical adjustment to monetary policy. Critics were hammering the Fed for being "behind the curve". The Fed chief still believed it had made the right decisions in late 2007 but a sudden spate of negative economic and financial data convinced him that it needed to change course. But when?

Mr Bernanke had pre-announced a big shift in policy in a speech on January 10. He hoped it would be possible to hold on until the scheduled Fed meeting on January 30 before making a dramatic interest rate change. But the slide in world stock markets through January had raised doubts as to whether the Fed could afford to wait.

The Fed chairman contacted his two most senior colleagues, vice-chairman Don Kohn and New York Fed president Tim Geithner, to debate moving forward the rate cut. The top Fed officials knew the cost of being seen to react to market moves. Whatever they said, it would revive the notion of a "Fed put" - a de facto guarantee against a sharp market decline.

But they reasoned that the costs of waiting were higher. A self-feeding market rout could take hold that would damage household wealth, raise the cost of capital for business and risk aggravating negative "feed-back loops" in the economy, with banks in particular pulling back from lending.

At 6pm Mr Bernanke convened the Federal Open Market Committee by videoconference and explained his judgment. There was resistence among the regional Fed presidents - Bill Poole, president of the St Louis Fed formally dissented. But Mr Bernanke carried the day.

At 8.20am on Tuesday the Fed announced it was cutting rates by 75 basis points - the largest single cut since the Fed began basing policy on the Federal Funds rate in 1990 - and promised more to come.

The move helped to arrest the market slide, but opinion among investors was sharply divided. "A 75 basis point cut eight days before the next meeting smacks of a panic," said Max Bublitz, chief strategist at SCM Advisors. Others were more upbeat. "The Fed did not panic, it took a very bold and risky gamble," said Macro Annunziata, chief economist at UniCredit Markets.

Mr Bernanke did not learn until a day after the cut that one reason why markets plunged on Monday was that Société Générale was unwinding billions in index futures trades built up by a rogue trader. For reasons that are unknown to the Fed, the Banque de France, which had known about the SocGen problem since at least Saturday and probably Friday, only briefed the Fed on Wednesday.

Mr Bernanke and his colleagues reasoned that even if they had known this on Monday, they would have acted the same way. But when the SocGen story went public on Thursday, many in the market concluded that the Fed had been bounced into action by a false signal.

Ed Yardeni, president Yardeni Associates, said the statement following the January 30 meeting should read as follows: "The Fed chairman panicked on Monday . . . He convinced all of us to vote for the rate cut except for cranky old Bill Poole. We now realize that the crash was caused by Société Générale which had to cover a massive long position in stock futures attributable to fraud committed by rogue trader Jérôme Kerviel. So we decided not to cut the Federal Funds rate again this time." Alan Rushkin, strategist at RBS Greenwich Capital, said: "The episode will further dent Fed credibility."

Many analysts were horrified at the lack of co-ordination between the Fed, the Banque de France and European Central Bank. "Is the level of communication between central banks as good as it once was?" asked Avinash Persaud, chairman of Intelligence Capital.

However, others were more willing to accept the Fed claim that information about SocGen would not have made any difference. "The idea that all this was caused by one trader's mistake is very convenient but there are worse things out there," said a senior European investment banker.

Richard Berner, chief US economist at Morgan Stanley, said: "There were a number of other market factors that were not related to SocGen and more to the downgrade of the monoline insurers." He added: "I personally believe the Fed thought they had gotten behind the curve, recognised that and wanted to catch up."

John Taylor, a professor at Stanford, said: "This to me was moving forward something that was going to happen anyway. The idea of doing it in the middle of very difficult market times seems to me was a good thing."

However, Alan Blinder, a professor at Princeton, said that while the substance of the Fed move was right, it was paying the price for not having moved on January 10 when Mr Bernanke gave his big speech. "The unfortunate thing was the timing," he said. Because the Fed tried to wait, then reacted to a market rout, it was exposed when it turned out the causes of the rout were not as the Fed believed.

For their part senior Fed officials insist the SocGen news will have no bearing on their decision on January 30 - when they are widely expected to cut interest rates by 50bp. Experts inside and outside the Fed say the evolution of the economy will ultimately show whether Mr Bernanke and his colleagues overreacted to market signals - or did what was necessary, possibly even a bit late in the day.

US Recession Fears Cause Global Equity Sell-Off

Fears of a US recession led to a sell-off in global equity markets on Wednesday, while rattled investors digested the latest earnings report from a Wall Street bank.

The Dow Jones Industrial Average fell 2.2 per cent overnight as weak retail sales data added to fears of further writedowns in the banking sector. Meanwhile, weak earnings from US chipmaker Intel (NASDAQ:INTC) after the Wall Street close also helped set the tone for Wednesday's losses.

Hong Kong's Hang Seng index fell 5.4 per cent - its worst day since September 2001 - as the territory's banking sector tumbled following damage to US rivals from subprime and credit market-related writedowns.

Tokyo's Nikkei 225 Average fell 3.4 per cent to a two-year low as export stocks such as Sony (NYSE:SNE) and Honda Motor (NYSE:HMC) fell on intensifying fears of weaker demand from the US.

By midday in Europe, London's FTSE 100 was down 1.5 per cent as miners slumped following sharp losses for industrial metal prices on commodity markets. Paris's CAC 40 lost 0.8 per cent and Frankfurt's Dax dropped 1.2 per cent. Futures trading indicated heavy opening losses on Wall Street, further undermining indices in Europe.

Citigroup (NYSE:C) of the US wrote off $18.1bn causing it to report on Tuesday a record $9.8bn fourth-quarter loss. Both Citi and Merrill Lynch reported plans to raise more than $20bn of fresh capital to shore up their battered balanced sheets.

Meanwhile, investors hoping for better news from JPMorgan were disappointed to hear the New York-based bank reported third-quarter earnings per share were lower than expected, and that it was "extremely cautious" entering 2008. The company was less exposed to credit and subprime markets, however, writing down only $1.3bn.

The dollar dropped to a record low against the Swiss franc and its weakest level in two and a half years against the yen on Wednesday as tumbling stock markets drove investors to the safety of low-yielding currencies.

Analysts said rising risk aversion had prompted investors to abandon carry trades, in which low-yielding currencies such as the yen and Swiss franc are sold to finance the purchase of riskier, higher-yielding assets elsewhere.

"Risk aversion is the only story in town, perhaps combined with a bit of dollar weakness," said Adam Cole at RBC Capital Markets. "The dollar is the perfect currency to sell against the yen in this environment."

The dollar fell 0.6 per cent to Y106.10 against the yen, its weakest level since May 2005, and dropped 0.4 per cent to an an all-time low of SFr1.0884 against the Swiss franc. However, the dollar was flat against the euro at $1.4810, as the single currency also suffered against the rampant yen.

Indeed, the yen rose 0.5 per cent to Y157.15 against the euro, climbed 0.7 per cent to Y207.95 against the pound and gained 1.4 per cent to Y81.86 against the higher-yielding New Zealand dollar.

Base metals extended the previous session's declines as fears of recession in the US offset expectations of strong demand in markets like China and India. Copper fell a further 2.2 per cent while zinc and nickel both declined 2.6 per cent.

The recent rally in the gold price, which saw the price climb to an historic level of $914.20 an ounce, ended as investors booked profits. The precious metal tumbled to $884.55, having ended the session in New York at $901.

Concerns about an impending recession in the US also sent oil prices to a three-week low. The Brent crude contract for February, which is due to expire today, fell $1.23 or 1.4 per cent to $89.75. The Nymex February contract declined $1.09 cents to $90.81 in after-hours trading.

ECB's Pleas for Restraint at Odds with Mood

Eurozone wage developments are being watched warily by the European Central Bank, which has signalled its readiness to raise interest rates if inflation shows any sign of spinning out of control.

But its pleas for wage restraint - likely to be repeated by Jean-Claude Trichet, ECB president, after Thursday's interest-rate setting meeting - have not found an echo in national capitals. The Frankfurt-based institution would risk political isolation if it made good its threat to raise official borrowing costs at a time when growth across the 15-country region is slowing and the euro is at a record high.

Meanwhile, companies' profits, not pay packets, are widely-seen as having gained most in the past few years, an argument that strengthens trade union's hands. Profits hit an all-time high of 40.7 per cent of eurozone gross domestic product in the third quarter of last year, according to UBS Investment Research.

Even talking about higher rates might appear politically provocative, especially when the US Federal Reserve and Bank of England are cutting borrowing costs in anticipation of tougher economic times. But at a six-year high of 3.1 per cent in December, eurozone inflation is way above the ECB's target - a rate "below but close" to 2 per cent.

Not yet 10 years old, the ECB is still burnishing its inflation-fighting credentials. It fears that the temporary "hump" in inflation driven by soaring oil and food prices will become longer lasting if it feeds through into higher pay settlements.

ECB forecasts, released in December, showed inflation returning back below 2 per cent in 2009. But ECB governing council members have stressed that those forecasts assume crucially that there is no general "pass-through" into wage demands. Some members last month voiced support for a pre-emptive rise in interest rates.

Mr Trichet warned senior members of Germany's ruling Christian Democratic Union last weekend that it was "essential" that wage-setting behaviour "remains unaffected by current inflation rates". The ECB would act to "ensure that such 'second round' effects ... do not materialise", he warned.

The problem for the ECB is that its fears about inflation do not fit with the political mood across the eurozone - forcing it to take a more strident tone. "Politicians are adding to the risk of 'second round' effects," says Holger Schmieding, economist at Bank of America. "That is clearly an argument for [the ECB] not even thinking about cutting interest rates."

In Berlin, and elsewhere, politicians are arguing that workers should take a larger slice of the economic cake. Nicolas Sarkozy, the French president, has promised to raise the salaries of public sector workers in return for a reduction in headcount and a reorganisation of career structures. He has also stepped up pressure on companies to talk to unions about the possibility of pay increases, threatening to withhold tax breaks and state aid if company bosses refuse to at least open negotiations with their staff.

In Italy, trade unions opened 2008-09 wage talks this week with a demand for lower taxes and more benefit payments to boost workers' spending power. Romano Prodi, prime minister, recognises the need for some tax cuts, but wants a deal with the unions that links pay with productivity and gives employers more flexibility.

Such debates have only intensified as inflation has risen, particularly in Germany where consumers appear highly sensitive to rises in food and fuel costs. The ECB had been "cornered" as a result, said Marco Annunziata, economist at Unicredit. "The erosion of purchasing power is felt strongly, so it is not surprising that governments across the European Union are sensitive to it."

UK Economic Uncertainty Gives Hope for Rate Cut

Uncertainty over the extent of the economic slowdown is expected to persuade the Bank of England to resist calls for an immediate further cut in interest rates when its monetary policy committee meets on Thursday.

A Reuters poll of economists last week showed that only 12 of 63 surveyed expected a rate cut this week although a larger number expected that the MPC would move rates lower in February following publication of its next inflation report.

"Our overall sense is that they probably will hold off [from cutting rates]," said Jonathan Loynes, economist at Capital Economics, noting that rising energy prices, and their knock-on impact on inflation, were likely to give MPC members pause for thought.

Last week, NPower, the gas and electricity supplier, announced it would increase prices by an average of 15 per cent, a move expected to be followed by its competitors in the industry. Rising energy prices have loomed large over central bankers in several economies, raising the spectre of inflation even as domestic growth stutters.

Inflation, Mr Loynes noted, remained a widespread concern. In a weekend interview, Gordon Brown, the prime minister, admitted more needed to be done "to break the back of inflation". He has vowed to limit public sector pay rises to below 2 per cent.

Moreover, it is not yet clear to the MPC that wage inflation is abating in response to slower economic growth. For example, the latest survey from Income Data Services showed a pick-up in pay rises last month to 4 per cent from 3.5 per cent, albeit from a relatively small number of pay deals. Far more crucial will be pay settlements agreed over the next three months which form the largest segment of salary deals. Meanwhile, Ben Broadbent, economist at Goldman Sachs, said that the economic data so far were not sufficiently gloomy to lead the MPC to conclude that a rate cut was needed right away. For example, the purchasing managers' index of business activity, on balance rose slightly last month and the key services segment showed a modest overall rise.

Even the credit conditions report from the Bank, issued late last week, offered some ambiguous messages on the economy. While secured lending to households - mortgage loans - had slowed sharply since the last survey and was expected to continue to do so, it was not clear that that was because applicants were being turned away.

Mr Broadbent said that the fall in new buyer inquiries, highlighted in the latest survey from the Royal Institution of Chartered Surveyors, suggested the drop might reflect falling demand from house buyers rather than a tightening of standards by lenders. In effect, it was not clear that home buyers were being squeezed so badly that the overall economy was in danger today, he said.

George Buckley, economist at Deutsche Bank, noted that another factor delaying a rate cut might be that although lending to households on a secured basis had tightened, it had done very little for unsecured lending - via credit cards, for example. That would suggest that consumers wanted to keep on spending.

Mr Buckley said he believed the next inflation report would give the MPC scope to cut rates, noting that historically, it was twice as willing to move rates up or down following publication of such a report than it was without one.

Where Financial Liberalisation Caught People

These are the glory days of the financial markets. They are bigger, richer and more powerful than they have ever been.

Yet it is that very position at the heart of global economic life that makes this year's credit squeeze a threat. Already, fairly or unfairly, a pantomime cast of predatory lenders, bankrupt bankers and teenage money managers has been lined up to take the blame. There are calls - some justified - for stricter regulation of financial markets. But before writing new rules, we should remember the financial world of 40 years ago, and where liberalisation has got us.

In the US 40 years ago, commercial banking and securities trading were strictly separated by the Glass-Steagall Act, and banks were unable to expand across state boundaries. On Wall Street and in the City of London, there were fixed commissions for share trades, and a closed circle of underwriting banks. Home mortgages came from building societies or a savings and loan and there was little competition on interest rates. Banks held a lot of reserves, but before the first Basel agreement on capital adequacy, reserves often bore little relation to a bank's risk. Exchange rates were fixed under the Bretton Woods regime and the international mobility of capital was restricted.

The liberalisation of these restrictions, mainly in the 1970s and 1980s, brought great benefits. The deregulation of financial markets led to a surge of competition and innovation. The cost of trading securities has collapsed. Banks have become bigger - and so in one sense more secure - and brought the techniques of the securities business to bear on banking. As a result of liberalisation, financial intermediation is cheaper, and we have a more complete and efficient set of markets.

Whereas 40 years ago many millions of young people may have wanted to borrow against their future income, in order to go to university or to buy a home, they struggled to do so. The liberalisation of consumer finance has eased credit constraints on many.

With the free international movement of capital has come a surge in direct and portfolio investment across borders. Not only has capital been allocated more efficiently as a result, but foreign investment has been a channel for the transfer of technology and management skills, and so increased growth. The wave of globalisation in recent decades would have travelled more slowly without financial liberalisation.

But for all this gain, there is a cost. Any relaxation in controls on banks' capital and activities makes it easier for them to take risks - and so increase profit - in the knowledge that the state cannot afford to let them fail. There is no simple answer, but a system of bank rescues in which shareholders lose all of their money creates the right incentives. Shareholders walked away from this year's bailouts of Northern Rock and Germany's IKB.

Consumer credit liberalisation also leads to a trade-off. Subprime mortgages made home ownership possible for hundreds of thousands of people who would otherwise have been tenants. Yet incompetent and fraudulent misuse of subprime mortgages has caused tens of thousands of those people to lose their homes as well as a shock to the financial markets. Regulation should be directed at the misuse and mis-selling of these products and not at the products themselves.

The greatest effect of financial liberalisation, however, has been to bind markets more closely together. A shock in the US mortgage market really can affect the availability of credit for a European consumer. To those consumers this is hard to explain, and feels like a threat, yet while the scope for financial shocks is now greater, there is little evidence that they have increased in frequency or in magnitude. Financial regulation, especially on bank liquidity and consumer lending, should be tweaked in response to the credit squeeze. But its liberal direction, which has brought great benefits, must remain.

European Banks Will Herald EU Crisis

The announcement before Christmas by the world's central banks of further measures to help restore liquidity to money markets was at first greeted with euphoria.

But, as with the US Federal Reserve's August 17 discount rate cut, it was not long before the measures were viewed as likely to be inadequate to deal with the size of the problem. The shift by the Fed to providing term liquidity via auctions has taken a leaf out of the European Central Bank's liquidity management manual. It may help. But with euro-area money markets having remained stressed - even after the extraordinarily big liquidity injections over the year end - it seems that money market liquidity provision alone is unlikely to solve the problem.

Should the financial crisis persist in spite of central banks' best efforts, the general perception is that the European economy would be less vulnerable than the US economy to its effects. That Europe has not generated on a large scale its own subprime asset class, the proximate cause of the recent difficulties, underpins this analysis. While some European banks might have been contaminated with subprime assets, it is argued, the waste is unlikely to be toxic enough to trigger a full-scale credit crunch. At the ECB's December press conference Jean-Claude Trichet, its president, suggested that still-strong bank lending might be an indication that "the supply of credit has not been impaired". The reality is more complicated.

At this stage, the challenge is to gauge the magnitude of the strains in the banking system and the extent to which future lending will be curtailed. The recent strength of bank lending in the euro-area reflects both re-intermediation and the difficulty of raising new finance in capital markets. It is therefore a sign of weakness, not strength, as it places even greater stress on bank balance sheets. A better measure of the credit squeeze is one that combines all capital-raising activities. The rate of increase in capital raised by companies in the previous 12 months in the form of bank loans, net debt and net equity issuance, for example, posted a drop of EU57bn ($83bn) between July and September, the biggest two-month decline since mid-2001, and was followed by only a modest recovery in October.

There are numerous other signs of an emerging credit squeeze. The rates that banks charge on loans have been creeping up despite the ECB having kept its policy rate on hold. Since July, the interest rate charged on loans to companies has increased by 25 basis points. The rate charged on mortgages has gone up by 17bp. Combining these metrics into an overall index, we find that bank credit conditions have tightened sharply and now stand at levels last seen in mid-2004. One hopes the new balance sheet and liquidity constraints facing European banks will not be too great to bear. In making our euro-area forecasts, we have calibrated the short-term effect to be equivalent to about a 75bp rise in interest rates that will be gradually eliminated by the end of 2009. That is more than most central banks and international institutions are assuming, and consistent with much slower bank lending next year. But in assessing the vulnerability of an economy to tighter credit it is necessary to gauge not only the extent to which banks will restrict their lending but also the importance of bank lending for financing economic growth.

According to the International Monetary Fund, about 60 per cent of private-sector liabilities in the euro-area and the UK consists of bank loans, while only 40 per cent is debt and equity. The 60 per cent figure for bank loans is higher than that of Japan's economy, where a broken banking system has contributed to more than a decade of poor economic performance. By contrast, bank loans account for only 20 per cent of private-sector liabilities in the US, with the rest accounted for by debt and equity.

This matters a lot. It means that, were banking systems to retrench significantly, the consequences for the economy are likely to be far greater in Europe than in the US. By symmetrical reasoning, however, the European economy is less vulnerable to a capital markets freeze than is the US. The lesson: in the US, watch the markets; in Europe, watch the banks.

Strong 2007 Year on Markets' Decoupling Talk

Markets across Asia followed a similar trajectory in 2007 - in four distinct phases.

First came a steady rise in the first half of the year, then a big sell-off in July and August as subprime worries came to the fore. Third, there was a new boom amid talk of Asian decoupling, before finally shares sold off again towards the end of the year as subprime worries returned. However, it looks like being a strong year overall, with the MSCI Asia-Pacific ex-Japan index up 27 per cent so far this year, even if it is down 14 per cent from its peak on November 1.

The decoupling story helped produce an extraordinary period of outperformance for Asian markets in September and October - extraordinary because emerging markets are normally hit hard in a global financial crisis.

In Hong Kong, for example, the Hang Seng index bounced back by 65 per cent from the worst day of August, to a lifetime high of 31,958 in October. It was helped massively by a well-timed announcement from Beijing that individual mainland investors might be allowed to buy shares directly on the territory's stock market.

But the rally ran out of steam towards the year-end, as investors questioned the Federal Reserve's ability to avert recession in the United States - traditionally Asia's biggest export market. The Hang Seng is currently 16 per cent below its peak.

There were exceptions to this pattern. Mainland China was one: shares in Shanghai and Shenzhen seemed to ignore the credit squeeze altogether in the dark days of August and continued to power ahead until valuations hit dizzying, perhaps unsustainable, levels.

Shanghai B-shares (which foreigners are allowed to buy) trade on average at 103 times earnings - similar to the p/e ratios of technology companies at the height of the dotcom boom in the US. The Shenzhen composite index is 146 per cent higher than at the beginning of the year, and Shanghai is up by 88 per cent.

Japan was another exception: a rally in the first half of the year fizzled out and the subprime crisis sent markets firmly on a downward path that continued for the rest of the year. The Bank of Japan's gloom on Thursday continued to cast doubt on the ability of the country's economy to emerge from its torpor. The Nikkei 225 Average was down 12.7 per cent on the year at its close on Thursday, while the broader-based Topix index was 13.3 per cent lower.

"There's no getting away from it," noted Peter Tasker, analyst for Dresdner Kleinwort in Tokyo this week, "the performance of the Japanese stock market over the past 12 months has been hugely disappointing". But that presents an opportunity. "Japanese earnings carry the lowest valuations in 25 years; relative to bond yields the lowest ever," Mr Tasker says. "The Japanese market is cheap enough and low enough to rally sharply if global policy tilts in a reflationary direction."

Whenever Japanese equity yields have dropped below bonds in the past, such as in late 1998, early 2003 and spring 2005, the market has bounced back strongly. Even if profits fell by 20 per cent they would still look like good value for money, Mr Tasker says. Further, many Japanese companies are much more globalised than they were a few decades ago, so their profitability is much more robust and their sensitivity to domestic conditions lower.

Taking Advantage of Dollar's Decline

The falling dollar may have made you think twice before booking that holiday to Chamonix.

But investors in exchange-traded funds - baskets of securities designed to track indices and trade like stocks - are discovering a variety of ways to profit betting against the greenback. The dollar's six-year slide has continued in recent months, and in November sterling traded above $2.11 for the first time since 1981.

The pound is up against the dollar about 34 per cent from five years ago, and about 10 per cent in the past 12 months. Meanwhile, the euro has risen 15 per cent against the dollar over the past year and 47 per cent in the past five years.

Ron DeLegge, editor of etfguide.com, an independent newsletter, says many ETF groups have recently introduced a slew of investment vehicles to make it easier for small investors to participate in global currency markets. "There's a lot more interest from investors who want to use different techniques to hedge against the dollar," he says. "You're not getting these offerings in mutual funds, so investors are gravitating towards ETFs."

ETFs have been the investment phenomenon of the past five years on Wall Street and Main Street. The first ETFs - introduced by State Street in 1993 - mimicked big stock indices such as the S&P 500. They were similar to traditional index funds, but had lower fees and were more tax-efficient. Today, however, there are more than 560 ETFs on the market, according to the Investment Company Institute.

DeLegge says investors looking to hedge against the weak US dollar are, for the most part, snapping up currency and gold ETFs. But perhaps the most straightforward way is by increasingly backing foreign equity ETFs. "Owning foreign equities hedges you not only against the dollar but also against a weakening economy," he says.

This year alone, assets within ETFs have grown by $167bn to $584bn, according to industry data. About $67bn, or 40 per cent, of that was dedicated to internationally focused ETFs.

Robert Huebscher, chief executive officer of Advisor Perspectives, the group that studies the investment trends of high and ultra-high net worth investors, says many advisers tend to shy from investing in currencies in favour of backing ETFs with foreign exposure. "For most, the currency markets are too hard to understand and predict," he says. "The smartest advisers are putting substantial amounts into foreign equity ETFs. They're betting on the fundamentals of non-US economies and non-US companies. This way, they're hedging their currency exposure and they can do just as well."

Most providers offer an array of international products. Vanguard offers ETFs including European, Pacific and emerging markets, while Barclays Global Investors - the biggest ETF provider in the US - offers more than 30 international ETFs.

There are also ETFs specifically designed to make leveraged bets on currencies. Rydex Investments and Powershares - two managers that have carved a niche in fund management by providing mutual funds with leveraged short and long attributes - offer ETFs that enable investors to short the dollar.

Rydex offers Eight CurrencyShares, a series of ETFs that track the price of eight currencies. Each holds one currency: the euro, Japanese yen, sterling, Australian dollar, Canadian dollar, Mexican peso, Swedish krona or Swiss franc.

An investor buys shares in a trust, and their value increases or decreases with the value of the currency relative to the US dollar. In other words, if the dollar drops, the shares gain. Meanwhile, Powershares offers both a bullish and bearish US dollar fund, based on Deutsche Bank's long and short US dollar indices. The indices are rules-based and composed solely of long or short futures contracts.

These are predominantly aimed at hedge funds and big institutions, says DeLegge, but they represent "the most direct play you can make on the dollar going down. "A lot of people don't understand, when you take a position in any one of those ETF products you're automatically shorting the dollar, because you're bullish on that other currency That's an important point."

Gold is another option for those seeking refuge from the dollar, says DeLegge. "Gold has historically been viewed as non-correlated asset - an area that does well when the greenback is collapsing," he says. "Investing in a gold ETF is a hedge against the dollar and also an inflationary measure."

State Street was the first to market with a gold ETF - the streetTracks Gold Shares - and now has $166bn in assets. State Street's ETF is 0.45 correlated to the dollar, according to Tom Anderson, director of strategy and research at State Street Global Advisors, which means that it has a strong but not infallible tendency to rise as the dollar falls. Its shares represent a 10th the price of an ounce of gold bullion.

The downside to ETFs, however, is their tax treatment, says DeLegge. Investors in these ETFs are treated as though they own "collectables", which means any long-term gains will be taxed at a maximum 28 per cent rate.

UK Economy in a Stress-Test

Does today's financial turbulence mark the end of the UK's economic miracle?

Is an economy that has enjoyed 61 quarters of positive growth and a cumulative expansion of 55 per cent since the second quarter of 1992 about to sink into recession? This is possible, but unlikely. Above all, if dire times come, the Bank of England has plenty of room to act, provided it retains its credibility over inflation.

The Organisation for Economic Co-operation and Development takes a measured view: in its latest Economic Outlook, it suggests that the UK economy will grow by 2 per cent between 2007 and 2008. It recognises downside risks, notably in the housing market, but opposite outcomes are also possible, not least because the impact of the credit squeeze remains highly uncertain.

Why, then, is the UK economy deemed particularly vulnerable by many observers? There seem to be six reasons: first, the UK's housing bubble is deemed bigger than that of the US; second, the UK is particularly dependent on finance and business services; third, the public sector is no longer in a position to increase employment rapidly; fourth, the size of the fiscal deficit makes it hard to counteract a severe downturn; fifth, in a housing downturn, the effectiveness of monetary easing might be limited; and, finally, the Bank of England is proving far too conservative.

It is, indeed, true that between the first quarter of 1996 and the third quarter of this year, real house prices rose by 148 per cent in the UK, against 127 per cent on the Case-Shiller index for the US (to the peak in the first quarter of 2006). More broadly, UK housing looks extremely expensive. Investment in housing is forecast by the OECD at a 10-year peak this year and well above current levels in the US, relative to gross domestic product. It might fall sharply. Given the role of housing as collateral, steep falls in house prices would surely slow consumption significantly. But, as the OECD notes, recent empirical work suggests that underlying demand might justify these high house prices. It is simply unclear how big is the threat from falling house prices to the economy.

The important of finance and business services for the UK is a fact. High pay in these sectors underpins the London housing market, which is the bellwether for the market in the country as a whole. As important is the way in which the financial sector bolsters the balance of payments. In 2006, for example, the UK earned £19.1bn in net investment income (1.5 per cent of GDP) on a net asset position of minus £305bn (23 per cent of GDP). This, then, is "hedge-fund" Britain: it borrows short, invests long and makes a large amount of money in the process. If this were to prove unsustainable, the current account position would be quite a bit worse.

That the growth of public sector spending is set to slow is well-known: in 2008, according to the OECD, real public consumption will grow by just 2 per cent. The implications for unemployment of slower growth in demand might not be that serious, however, precisely because the UK labour market is so open. If there were a big downturn, some (perhaps many) immigrants would return home, particularly those from other members of the European Union who know they can return in better times.

Probably more important is the fiscal deficit: the UK's general government financial deficit is forecast at 3.4 per cent of GDP next year by the OECD, which is disturbing, to say the least, at such a favourable point in the cycle. While further increases in deficits would be possible, they would only be justified in extreme circumstances, such as those experienced by Japan in the 1990s. In normal times, fiscal policy is, alas, foregone. That is Gordon Brown's legacy to his successor as chancellor, Alistair Darling.

That leaves monetary policy. Contrary to the many critics, I sympathise with the cautious stance taken by the Bank of England in the recent crisis. But it is now quite clear that markets have imposed a persistent and significant monetary tightening, with the interest rate on three-month interbank borrowing still a full percentage point above the Bank's target rate. This is almost certainly far too high for current conditions. The Bank should either lower its target rate further or act even more energetically to close the gap between its official rate and those on interbank lending.

Fortunately, the Bank does have vast room for manoeuvre, since it has much the highest official rate of any large advanced economy. With a floating exchange rate, aggressive monetary loosening would probably lower the (in my view, overvalued) exchange rate against both the dollar and the euro substantially. That would help support and rebalance economic activity across the country.

There is, however, a caveat. But it is also a crucial one: the Bank cannot act aggressively if the credibility of low inflation comes into question. It is precisely for this reason that it must not abandon all caution. It will be able to rescue the real economy if and only if low inflation remains believable. It is as important for the Bank to be seen to stick to its fundamental mandate today as it has ever been. Flexibility is the reward of credibility. The Bank understands that. So should everybody else.

Fed to Overhaul Provision of Market Liquidity

The Federal Reserve is set to announce as early as on Wednesday a fundamental overhaul of the way it provides liquidity in financial markets in a bid to tackle head-on severe strains in the interbank money market.

The US central bank is expected to unveil a new liquidity facility through which it will auction loans to a large number of financial institutions, accepting a broad range of securities as collateral in return.

The move reflects a realisation among top Fed officials that their existing tools - open market operations and direct discount window loans - are having little effect on painfully high rates in the market for term interbank loans.

These are loans made by one bank to another for periods of up to a few months. The Fed is able to control the overnight federal funds rate by pumping in liquidity through open market operations.

However, the money is not flowing from the overnight market into the term interbank markets. Only a small number of primary dealers can access money directly from the Fed through open market operations. These financial institutions appear reluctant to lend the money on to other banks, in part because they do not want to expand their own balance sheets, and in part because they are worried about the creditworthiness of their counterparties.

Moreover, the open market desk is prohibited from accepting most mortgage securities as collateral. A large number of banks can in principle borrow directly from the Fed through the discount window against a wider range of collateral. But in a recent speech Don Kohn, vice-chairman, said the market "stigma" of borrowing from the Fed was preventing the discount window from serving its proper function as a backstop to market liquidity.

As a result, most mortgage lenders are turning to the Federal Home Loan Banks rather than the Federal Reserve as a lender of last resort. The new Fed plan aims to change that. The precise details of the new facility are not known. But it is loosely modelled on a 2000 Fed working paper that proposed creating a facility that would auction credit to banks.

This came at the time when the US central bank worried that the US government might repay all its debt, eliminating the market for Treasury securities through which the Fed conducts open market operations.

Fed officials have dusted down this proposal and adapted it to address the current credit market crisis. Vincent Reinhart, a fellow at the American Enterprise Institute and former chief monetary economist at the Fed, says this kind of auction facility would allow the Fed to provide funds directly to a much larger group of banks than the limited number of primary dealers who participate in open market operations, against a wide range of collateral, without the stigma of the discount window.

"I think it would be very positive," he says. Banks in need of liquidity could acquire funds relatively anonymously, while the large number of participants with direct access to Fed money would encourage arbitrage to exploit the gap between cheap Fed money and high interbank rates.

Moreover, the Fed could auction funds at whatever term it wanted to in order to target liquidity at particular term markets - for instance, the market for one-month loans. It would have the option of either auctioning a fixed amount of funds, or offering to supply whatever funds were needed at a target rate.

The intended interest rate spread over the Fed funds rate is not known. If the Fed decided to auction loans at or only slightly above the Federal funds rate, it would risk subsidising weaker banks, which normally pay a premium to borrow in the interbank market. However, Mr Reinhart says this could be dealt with by varying the amount of collateral required in return for loans based on the creditworthiness of the bank seeking funds.

Wealthy's Desire for Luxury Rises Unabated

Wealthy people's taste for luxury has been untarnished by the recent economic slowdown according to new research, which found more people were willing to splash money on private jets, concierge services and personal shoppers.

The latest survey from Barclays Wealth says that rich people increasingly want to buy luxury services to save them time and stress. Barclays said the use of private jets was set to increase significantly. More than half of the survey respondents in the US and Canada, Italy, Singapore and Portugal said they planned to fly privately rather than first class on airlines.

Gerard Aquilina, head of international private banking at Barclays Wealth, said the use of private jets had increased in popularity as they enabled people to bypass airport and security delays. "The idea of wealth goes further than the ability to buy goods and services. It also provides a sense of empowerment and control," he said.

The survey shows that more wealthy individuals plan to take advantage of personal shoppers, fitness trainers and concierge services. Barclays said for many wealthy people the biggest luxury was having more time. Two-thirds of respondents believed their wealth had brought them more leisure time, mainly because they enlisted the help of a number of people to run their day-to-day lives.

Mr Aquilina said there had been a "dramatic" rise in the number of wealthy individuals using family offices to manage everything from their investment portfolios to travel arrangements. "There is a growing desire among the wealthy to have something unique and something that to some extent allows them the freedom to control time," he said.

Of the respondents with assets of at least $3m (£1.47m), almost 80 per cent employed a butler and a chef, more than three-quarters used a personal stylist and more than half consulted a personal shopper, personal trainer, dietician and travel consultant.

The survey showed there was a rapidly rising demand for bodyguards around the world, particularly in some parts of continental Europe, Asia, South Africa and the Middle East. Barclays found that people's perception of wealth had changed. More than a third of the respondents thought people needed liquid assets of at least $10m before they were considered rich.

Barclays said the rising cost of luxury goods and services meant people needed this much wealth to feel secure and able to enjoy their money.* Storm clouds may be looming over the rest of the property market, but wealthy buyers are queuing up for rural estates in Scotland, Andrew Bolger reports. CKD Galbraith, the property consultant, estimates the overall estates market in Scotland has about 100 potential buyers on a "waiting list" who are ready to spend collectively about £300m. Most of the interest came from continental Europe.

Bank of England Pressure to Cut Rates Intensifies

Pressure mounted on the Monetary Policy Committee to deliver a cut in UK interest rates on Thursday, after a clutch of weak data suggested the economy was slowing more abruptly than the Bank of England had hoped.

The purchasing managers' index of services activity, which the Bank of England relies on to improve its estimates of economic growth, fell from 53.1 to 51.9 in November. This is its lowest level since May 2003, when interest rates were only 3.75 per cent. In the housing sector, the Halifax index showed a fall for the third month in a row.

By Wednesday evening, money markets were betting on an 80 per cent probability of a cut - up from little more than a 50-50 chance at the start of the day. The pound had fallen 0.9 per cent against the currencies of Britain's main trading partners and many City economists fretted they had made a mistake in predicting rates would remain on hold at 5.75 per cent.

Investors warned of a turbulent reaction if rates were not cut. "The market seems hell bent on a base rate cut tomorrow," said David Buik of Cantor Index. "If they don't get one, hold your breath for a roller coaster ride."

Several analysts, including those at Barclays Capital, ING and Global Insight, changed their rate call from hold to cut and others said the decision was simply too close to call. Analysts said the purchasing managers' survey showed credit market worries were acting as a brake on the wider economy and could give the Bank the evidence it would need to justify cutting rates from their current level of 5.75 per cent.

"Demand for services has eased over the past three months with signs that firms serving the consumer are finding life increasingly difficult," said Ian McCafferty, the CBI's chief economic advisor.

The MPC has already signalled in its November inflation report that rate cuts were needed to stop inflation falling too far in the medium term, but said the outlook was highly uncertain. It faces a current problem in balancing the risks of slowing activity with those of rising inflationary pressures. The British Retail Consortium on Wednesday said higher food prices had fuelled the highest rate of shop price inflation so far this year.

Evidence of slowing service sector output was coupled with growing gloom over house prices. The Halifax said house prices fell 1.1 per cent last month, much weaker than expected, bringing the annual rate of house price inflation down from 8.9 per cent in October to 6.3 per cent.

While monthly changes in house prices are often volatile, the Halifax index has now fallen 2.4 per cent over the past three months. Michael Saunders, economist at Citigroup, said the fall was "the greatest for any three-month period since the dark days of 1992" and could be a prelude to sharp falls in consumer demand.

UK Housing Market Set For a Squeeze

Fears that the credit squeeze will hit the housing market were reignited on Wednesday after a warning that rising borrowing costs are leaving banks struggling to find the money to fund new mortgages.

Three-month interbank interest rates - the price at which banks borrow from each other - hit 6.59 per cent on Wednesday, a level not seen since the week the Treasury stepped in to save Northern Rock depositors.

Raised borrowing costs are dealing a severe blow to smaller lenders, who have few alternative financing options, the Council of Mortgage Lenders said on Wednesday. Figures from the Land Registry showed the first tentative signs of house prices falling in London - 0.6 per cent down in October on the previous month.

The rise in three-month sterling Libor came as Jackie Bennet, head of policy at the CML, told a City audience it was an illusion to think banks' retail deposits could cover any shortfall in wholesale funding for mortgage lending. "There is not enough retail funding about to fund mortgage markets if the capital markets do not open next year," she said.

Net mortgage lending in the UK has averaged about £9.5bn a month over the past year, while Bank of England figures show retail deposits have grown by an average of £6bn a month over the same period. With short-term wholesale lending markets seized up and other funding strategies, such as covered bonds, facing difficulties, the shortfall in bank financing is likely to drive up mortgage costs, making loans harder to obtain

While many in the markets are still hoping the Bank of England will intervene to boost three-month liquidity, senior bank officials are saying privately that they are unsure there is anything they can do to temper the rise. While they have met banks' demands for immediate liquidity - holding the overnight Libor rate at close to 5.75 per cent - they are unsure if they should cut rates on longer maturities even if they felt it would work.

The Bank's reticence in providing term liquidity contrasts with that of the US Federal Reserve. On Wednesday, Don Kohn, the second most senior official at the Fed, dropped what investors saw as a clear hint that it was willing to cut interest rates again next month if market conditions did not improve. His comments, that the central bank would be "flexible and pragmatic" prompted a surge in global stock markets which sent the FTSE 100 up 2.7 per cent at 6306.2. The Eurofirst enjoyed its biggest one-day rise for more than four years while the S&P 500 was up 2.58 per cent at luncthime.

But for all the cheer in equity markets, economists expect little good news in the coming days. The first concrete sign of a crunch in credit availability is likely to emerge this morningwhen Bank of England figures are expected to show a large fall in mortgage approvals for October. Weaker house-price inflation figures are also expected to be published by the Nationwide building society.

Stocks Slide Despite Fed Move on Funding Fears

US stock prices and bond yields plunged on Monday as credit fears grew in spite of aggressive efforts by the Federal Reserve to head off a year-end funding squeeze.

Traders said investors were shifting out of equities for the security of government debt in a flight to quality that gained momentum in the final hours of trading. US bond yields touched their lowest levels in more than three years, while the S&P 500 index finished 2.3 per cent lower, 10 per cent off its record high in October - a technical "correction" in stock-market parlance.

"This had all the fingerprints of a massive allocation shift out of equities and into long-dated bonds," said William O'Donnell, UBS interest-rate strategist.

The US trading day began with the Fed promising to ensure there was enough money in the system to keep the overnight borrowing rate at or near its target level, now 4.5 per cent, around December 31. It announced a series of long-term liquidity operations to span the new year, starting with an $8bn repo deal that matures on January 10. These operations will allow banks to lock in funds to carry over the year end.

A New York Fed official said "we hope to reassure market participants of our commitment to providing sufficient balances at that time by starting to provide these balances now." The US central bank also said it was relaxing the terms on which market participants could borrow Treasury securities from its own portfolio, in a bid to help meet intense demand for these safe asssets.

The Fed move came as HSBC, Europe's largest bank, unveiled plans to take on to its balance sheet $45bn (£22bn) of debt - much of it mortgage-linked - that is owned by structured investment vehicles (SIV) it manages. HSBC said its decision to bail out its SIVs would provide certainty for investors in the funds, for HSBC shareholders and for the bank and could help support the broader market by removing the threat of a firesale of the assets its vehicles held.

However, its decision to go it alone deals a blow to US banks attempting to push through a US Treasury-backed plan to create a so-called super SIV. HSBC will not provide any of the liquidity for the super SIV as the US banks had hoped. Shares in banks began selling off in late London trading after Goldman Sachs said HSBC might need to make an additional $12bn of provisions for its US subprime mortgage and home equity loan exposure. The FTSE 100 fell 1.3 per cent.

Losses were heavier in New York as the S&P ended up in negative territory for the year and investors piled into government bonds. Yields on two-year Treasury note fell 19 basis points to 2.885 per cent, its lowest level since November 2004. The 10-year Treasury fell 16 basis points to 3.835 per cent, its lowest level since March 2004. Shares in Citigroup, which has the largest exposure of any bank to SIVs, fell 6 per cent, its lowest level in more than five years.

The latest Fed moves, which coincide with new expected money market operations by the European Central Bank today, come amid increasing fears that financial turmoil could spill over into the real economy.

Dollar Safe from Challenge of The Euro

Less than six years ago, as euro notes and coins were launched, politicians sought to champion the new currency.

"The euro could become a reserve currency with equal status to the dollar," said Hans Eichel, then Germany's finance minister. Back then the euro was worth less than 90 US cents. This week, as the euro heads towards $1.50, lifted by speculation that the world's central banks might cut links to the dollar and switch to its younger rival, Europe's politicians might regret what they had once wished.

The threat to exports from a strengthening euro is sounding alarm bells across the continent, raising concern that the eurozone is bearing an unfair burden of global economic adjustment and that a significant economic slowdown lies ahead.

In spite of politicians' worries, however, few economists expect that the euro will threaten the dollar's global role in the foreseeable future. The euro has notched up successes: the value of euro notes in circulation now comfortably exceeds the value of dollar bills and the euro has overtaken the dollar as the main denomination of international debt issues.

But a switch from pricing oil in dollars to euros, as mooted by some, would have largely symbolic significance. More crucially, the dollar still forms by far the largest part of official foreign exchange reserves.

"Nobody knows what will happen in 20 years from now but this process of substituting a leading currency with another one is a long process," says Otmar Issing, former chief economist at the European Central Bank. "The incumbent always has advantages."

A greater international role for the euro would reflect logical diversification by central bankers - and could be seen as a tribute to its underlying strengths. Mr Issing, a former Bundesbank official, recalls how in the 1970s Germany's central bank was wary about the global status of the D-Mark and the additional responsibilities it felt, but came to change its mind. "As a central bank, it [the currency] is your baby. And if it is so widely appreciated, it is an expression of credibility and trust in the future stability of the currency."

Will the global attention on the euro create problems for the ECB? Simon Derrick at Bank of New York Mellon dates the start of the currency's long-term rise to eurozone politicians' lobbying efforts earlier this decade. Between early 2002 and the second quarter of this year, the euro's share of known official foreign exchange reserves rose from 19.7 per cent to 25.6 per cent, according to International Monetary Fund figures. One advantage for the ECB, Mr Derrick argues, is that it has not had to be as aggressive in lifting interest rates - the stronger euro has done its work for it. "But it means that they don't have the whip hand when it comes to how tight monetary conditions are."

Still, that would have been true whatever the causes of the euro's appreciation. Meanwhile, the ECB would argue strongly that, like the US Federal Reserve, it sets monetary policy in the best interests of the geographical region for which it has responsibility.

Talk about the international role of the euro is, anyway, likely to prove inflated, says Holger Schmie­ding, economist at Bank of America. "Regardless of short-term cyclical fluctuations, the long-term demographic and economic prospects for the US economy and currency are better than for the eurozone. Once the dollar has hit its cyclical bottom, talk of the euro dethroning it will die down."