Daily Archives: October 10, 2008

By John Muellbauer

Fed minutes released on October 7 disclosed that as recently as Sept 16, Fed officials thought risks to growth and inflation were roughly equally balanced. And Federal Reserve Chairman Ben Bernanke acknowledged on the same day that though the inflation outlook had improved somewhat, it remained uncertain. The market may have taken these views as representative of central banks round the world, particularly given the ECB decision of October 2 not to reduce rates. Following these releases, the Dow Jones index fell by about 6.5 percent as the market thought the internationally co-ordinated interest rate cut it had been expecting had become less likely. This and the knock-on effects on world markets then helped to force central banks to make the cut the market had expected, but on October 8.

Central banks’ caution about inflation risks is understandable given the experiences of 2008. Forecasting inflation is notoriously difficult. There have been big structural shifts in the world economy such as trade and financial globalisation and in individual economies, such as the decline in trade union power. Monetary policy itself has shifted to a far greater focus on inflation. Energy and food price shocks can be large and very hard to predict. Indeed, the speed of price changes tends to increase with big shocks. Most forecasting models used by central banks therefore put a large weight on recent inflation. This tracks inflation quite well except at turning points because the models miss key underlying influences. Read more

By Graham Turner

The markets have given their emphatic response to the banking bailouts put forward in the UK and US. Both rescue packages are flawed and will fail to stem the slide into not just recession, but possibly a global depression.

These bailouts were aimed at the symptoms, rather than the cause. Money markets are frozen because nobody knows how far property prices will slide, or the scale of losses banks will suffer. Banks are deemed insufficiently capitalised for the same reason.

The policy response of Western governments has, therefore, been back to front. If they solved the underlying problem – chronic property deflation on a scale not seen since the 1930s – liquidity will eventually return.

There is only one conventional policy that will work: deep interest rate cuts followed by a shift to quantitative easing. Read more

By Laurence Kotlikoff and Perry Mehrling

So now Uncle Sam has an additional $700 billion to work with.  Will it be enough?  It depends on what he does with the money.

The original idea was to buy assets outright, $700 billion worth and then we’re done.  But the debate has moved on, and today’s idea seems to be to use the money to recapitalize the banks by making a $700 billion investment in preferred stock.  There is no question that this approach would give you more bang for the buck, but there is an even better way.

In recent discussion, the preferred stock injection has been described as a kind of insurance, and so it is.  FT readers know this: “US may follow UK on bank bail-outs”.  The yield on the stock is like the premium on the insurance, and the total injection is like a cap on the total amount of claims that will be paid.

The problem is that no one knows how much the total claims might be in the absolute worst case scenario.  And a preferred stock injection provides no protection against that worst case scenario.

What the system needs most is not protection against the next 10% of losses – the Warren Buffetts of the world are happy to provide that – but protection against everything that might possibly come after that.  What the system needs is a credit insurer of last resort. Read more