The global economy is in a funk, the banking industry is in meltdown, house prices are collapsing, and companies are starting to default on their debts — so central banks are threatening to crank interest rates higher. Go figure.
Anti-inflation zeal is coercing the self-appointed guardians of financial stability into policy mistakes of epic proportions. Here’s an imaginary conversation that could have taken place in recent weeks between Federal Reserve chairman Ben Bernanke and European Central Bank (ECB) president Jean-Claude Trichet.
“Ben, I just wanted to thank you for talking the dollar off the ledge yesterday. At $1.60, I really would have been tempted to intervene in the currency markets to tell the euro bulls that enough is enough.”
“My pleasure, Jean-Claude. You know how keen I am to expand the Fed’s arena of responsibility, and currency policy seemed ripe for a takeover. Besides, I can barely afford to fuel my Ford Hippopotamus for the drive to work, so it’s helpful to give those pesky oil speculators something to chew on. If oil gets to $200 a barrel, I can kiss my second term goodbye.”
“There’s just one problem, Ben. I’m going to raise rates before the summer ends, and the Bundesbankers are bullying me to warn the markets in advance. As soon as I do, the euro will be off to the races again.”
“You’re in luck, J-C. The guys and I are thinking along the same lines. How about you use your regular press conference tomorrow to fire a warning shot, and next week I’ll follow with some mumbleswerve about commodity prices?”
On 3 June, Bernanke said: “We are attentive to the implications of changes in the value of the dollar for inflation and inflation expectations.” Two days later, Trichet said: “We could decide to move our rates by a small amount at our next meeting.” This week, Bernanke said officials will “strongly resist” any increase in expectations for faster inflation.
So, Helicopter Ben has parked his whirlybird in the hangar. Trichet has finally decided that inflation, which has overshot ECB’s 2% target every year since 1999 and is currently running at a 16-year high of 3.6%, merits the first policy move in a year.
This is madness. Consumer confidence, undermined by unemployment worries and headlines about the real estate crash, is too fragile to withstand an increase in borrowing costs. The banking industry needs a steep, positive yield curve, with low short-term rates and higher long-term rates, to repair balance sheets.
Anyone who was considering buying battered bank stocks — the Standard and Poor’s 500 Financials Index is down more than 20% this year, while the Bloomberg 500 Banks and Financial Services Index has shed more than 25% of its value — should think again. Every time a financial leader says the worst is over, another landmine goes boom.
This week it was the turn of Citigroup Inc. CEO Vikram Pandit, who told the British Bankers Association’s London conference that liquidity is recovering to “normalized” levels. Tell that to the money markets, where three-month rates for dollars, euros and pounds are all at least 79 basis points above the relevant central bank levels.
And what happens if the Fed decides not to renew those acronymic liquidity facilities, the TAFs and TSLFs and PDCFs, it generously supplied? Lehman Brothers Holdings Inc.’s dash to raise $6 billion of fresh capital — two months after chief executive Richard Fuld said “the worst is behind us” — might look like a very smart U-turn.
The futures market says there’s a more than 40% chance that the Fed will raise its key rate from 2% when it meets on 5 August. A week ago, there was zero likelihood of higher borrowing costs. The euro futures contract for September settlement trades at 5.17% compared with ECB’s 4%.
Higher official borrowing costs could rapidly sink companies already struggling to pay their debts. Moody’s Investors Service said this week its global default rate for sub-investment grade borrowers has doubled to 2% since the end of last year. By the end of this year, the rating company expects the rate to surge to 5%.
“Many speculative-grade issuers will face mounting financial pressures over the remainder of the year as a weak economy negatively impacts issuers’ revenue growth, and reduced access to credit markets limits their ability to modify debt service obligations,” Kenneth Emery, director at Moody’s, said in a research note.
Higher policy rates might make Western central bankers feel macho and proactive in suppressing inflation expectations. In truth, officials are powerless to stop aftershocks from the sprint to prosperity now under way in China and India. Inflation-beating dogma in times of stress risks turning the current financial drama into a full-blown economic crisis.
Mark Gilbert is a Bloomberg News columnist.
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