There are two ways to respond to the US Federal Reserve chairman Ben Bernanke’s decision on Friday to cut the discount rate, which is the rate at which it lends to American banks.
One, you can take the cheerful view that like all interest rate cuts in the recent past, this one too will send torrents of money flowing back into the markets, thus lifting the prices of all types of assets. Two, you take the darker view that Bernanke’s out-of-turn cut is an indication that the problems in the global credit markets are far more serious than most of us believe. And remember that it comes after a huge injection of liquidity by the Fed and the European Central Bank, in early August, did little to stabilize the markets.
We tend to lean towards the more bleak interpretation. We have often argued in these columns over the past month that the turmoil in the financial markets does not amount to a temporary pause for breath before prices continue on their steep and unstoppable ascent. The knee-jerk bullishness of many experts featured in the newspapers and on television, especially in the early days of trouble, was essentially thoughtless. There are recent instances when entire markets have been frozen in inactivity because there are no buyers for the alphabet soup of derivatives that investors hold. It is still not clear how deep the rot in some of these markets is. To tell investors to be happy and not worry is irresponsible.
It is interesting that Bernanke has decided to decrease the discount rate rather than the federal funds rate, which his predecessor Alan Greenspan usually tinkered with when he was faced with a similar situation. By lowering the discount rate, the Fed has ensured that commercial banks will be able to borrow from it more cheaply than before. This is very much the traditional approach of central banking, and it usually worked in the bygone era when it was commercial banks that dominated the financial system.
This is no longer the case. Financial risk has been diced and parcelled out to various types of investors. Some of the more innovative—and opaque—derivatives are thinly traded and the investment banks that own them have suddenly found out that many of them may be close to worthless, given the scarcity of buyers. So, it’s not clear whether the affected in the financial system can be quarantined by the Fed as easily as before.
By throwing a hasty lifeline, the Fed is perhaps postponing the moment for tough decisions, as the Bank of Japan did with almost suicidal effect in the early 1990s, when Japan’s own bubble economy went pop. It is intriguing that the markets are rejoicing at the drop in short-term borrowing costs for commercial banks when the main problem is a credit crunch in the riskier ends of the market.
There is, as yet, no sign that governments and companies with very good credit rating are feeling the pinch. In fact, the interest rates on US government debt have already dropped because of the “flight to quality”—where investors have dumped risky loans and moved into safer havens.
Does this mean that markets will continue to drop in the coming weeks? Frankly, we have no idea and, we suspect, nor do most of the experts out there. But the financial future is not only about the headline news on how the Dow Jones or any other major stock index is doing.
The recent jolts to the markets should ensure that there will be more price volatility and that credit spreads will widen. What this actually means is that investors round the world are being shaken out of their stupor.
That’s why we welcome the recent dramatic swings in markets around the world —they will force the investor to be more careful. Bad news can be good news in an era of overconfidence.
(Did the markets need a bout of volatility and fear? Write to us at firstname.lastname@example.org)