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As turmoil continues on financial markets the threat of another rise in ECB interest rates in early September appears to have fallen dramatically. Indeed, today’s action by the US Federal Reserve and comments from the ECB suggest Central Banks are significantly stepping up their response to current problems in the credit markets.
The Federal Reserve today took markets by surprise when it cut one of the interest rates that it uses to supply liquidity to the US financial system. It should be noted that the discount rate which it cut today is not the main policy interest rate it uses to steer monetary policy and the US economy. The ‘Discount rate’ is applied to funds supplied to commercial banks who cannot source all the liquidity they require in the interbank money market. As a result it is a back-up facility and is usually set at a penal rate above the Feds main policy rate; the Fed funds rate. By cutting the discount rate today from 6.25% to 5.75%, the Fed is making it cheaper for Banks to get additional funding direct from the Fed itself (rather than from other banks in the money market). It also means that additional and cheaper liquidity is going to those banks in most need rather than into the broader economy. (Traditionally there has been something of a stigma attached to discount borrowing as well as a higher rate. So banks don’t tend to use it widely.) However, the discount rate is still well above the Fed funds policy rate 5.25% and today’s action is intended to signal that policy is not changing. In practice, however, the Fed is effectively adjusting policy. There are two other noteworthy aspects to today’s Fed action. First of all it has allowed banks to borrow for 30 days rather than overnight. So, it will provide support to institutions for a somewhat longer timeframe. Second, the Fed in the accompanying statement noted that ‘financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably. The Committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.’ This statement suggests that the previous ‘bias’ towards inflation concerns has gone and the Fed may now be primarily focussed on downside risks to the economy. The key question is whether markets feel today’s Feds policy action is sufficient to boost confidence and restore a lasting calm to financial markets. While the immediate reaction of stock markets is very encouraging, it remains to be seen whether a full policy shift might still be necessary at the Fed’s upcoming policy meetings on September 18th or October 31st . At the least, today’s move buys the Fed some time.
Separately, comments by Bundesbank president and ECB governing council member, Axel Weber, this morning suggest the ECB is reconsidering the September rate increase signaled by ECB President Trichet on August 2nd. Weber is usually seen as one of the most hawkish members of the ECB council and so, his apparent ‘stepping down’ of the prospective rate rise represents a significant development.
His comments today have to be seen in the context of a very carefully orchestrated process by which the ECB has prepared the markets for interest rate hikes. In early August, Trichet signaled the prospect of a September rate rise by saying that ‘strong vigilance is therefore of the essence to ensure that risks to price stability over the medium term do not materialise’. When asked whether this phrasing meant as in the past that rates would rise the following month, Mr. Trichet reported ‘they have exactly the same meaning as before’. However, Mr. Trichet did leave some wriggle room by adding ‘do not forget we never pre-commit’. With the ECB’s monthly bulletin published on August 9th repeating the need for ‘strong vigilance’, it appeared a rate rise on September 6th was virtually set in stone.
The recent financial market volatility has raised some doubts about the prospect of a September rate rise, particularly as it has coincided with some slightly disappointing real economy data of late. However, because of the clarity of the early August signal rate increases by the Reserve bank of Australia and the Norwegian Central Bank in the past couple of weeks as well as tough talk by Bank of England policymakers, markets have tended to the view that inflation worries still remain the primary focus for most Central Banks.
Mr. Weber was asked today if the ECB is still ‘strongly vigilant’. According to Bloomberg newswire he replied that ‘we’ll meet our mandate. Our mandate is price stability and financial stability. We’re responsible for both and we take both into consideration’. This reply is significant by pointedly refusing to use the phrase strong vigilance, Mr. Weber suggests that the anticipated September rate rise is now in question inside the ECB. The consistent usage of the same code words ahead of each ECB rate rise means his remarks can’t be dismissed as a slip of the tongue. This doesn’t mean that ECB rates cannot rise in September but that the decision will depend on the behaviour of financial markets in the interim.
Today’s comments by Mr. Weber change the outlook from the virtual certainty of a rate increase to the strong likelihood that ECB rates won’t rise next month unless there is a sustained and substantial easing in market turmoil. The ultimate peak in Euro area interest rates also seems lower than seemed likely a month ago. RELATED © Copyright 2007 by Finfacts.com |
