With the collapse of privately owned and lightly regulated financial intermediation in the North Atlantic region in full swing, the focus of attention has quite naturally switched from the central banks to the Treasuries/ministries of finance. Central banks can and should provide liquidity on demand – after all, they can produce it for free. Central banks should not be asked to provide capital to insolvent banks, even if they could do so without endangering their price stability mandates. Central banks should be automatically and immediately indemnified by the Treasury for any losses suffered through the acceptance of risky collateral, through unsecured lending to private counterparties or through the outright purchase of risky private securities. Subsidies should be explicit and on the books and budget of the Treasury rather than buried in quasi-fiscal interventions by the central bank.
Central banks should, of course, continue to set their official policy rates to pursue their macroeconomic stability mandates: price stability for the Bank of England and the ECB and price stability and sustainable growth for the Fed. I believe that in both the UK and the euro area, real economic conditions have deteriorated so quickly and to such an extent that the balance of risks is now for the inflation target to be undershot rather than overshot over the horizon that the central bank can influence the inflation rate.
The accelerating collapse of the banking system and the complete lack of confidence of the banks in each other’s creditworthiness and of everybody else in the creditworthiness of the banking system, have effectively halted intermediation via the banking system between economic entities with financial deficits and surpluses.
The magnitude of the Libor-OIS spreads, the CDS rates for banks and other financial instutions and other spread measures of credit risk support the view of a banking system closed for business, as far as the real economy is concerned. A few of the larger and better-known corporates can bypass the banks and issue directly in the capital markets, but this option is not open to smaller and newer firms. All they can do is hunker down and cut back first on fixed investment, then on working capital and ultimately on employment. The economies of the euro area and the UK have entered a recession that is likely to be both deeper and longer than seemed likely even a month ago.
As a result, the prospects for inflation have changed too. Weaker oil and commodity prices are pushing in the same direction as growing excess capacity and labour market slack. In the euro area inflation appears to have peaked already, and is expected to fall sharply in the months to come. In the UK we are, if not yet clearly beyond the headline inflation peak, at or close to it, and the prospects are for a rapid decline in inflation in the near future.
So the case for interest rate cuts both in the euro area and the UK are strong indeed now, not because of any non-specific confidence effects or because this will help the solvency of their bankings sectors. While lower official policy rates do indeed permit banks to recapitalise themselves (provided the yield-curve is upward-sloping), the timing and scale of such official-policy-rate-led recapitalisation are such as to make it relevant to the resolution of the current crisis. Lower rates are required because an unexpected weakening of the real economy (caused by the collapse of the banking system) has increased the downside risks to inflation.
By how much and when should the Bank of England and the ECB cut their official policy rates? For both I would consider a 50 basis points immediate cut to be appropriate. When is immediately? For the Bank of England, this should be at the next regular rate setting meeting, on Thursday October 9. The ECB just met last week and decided to keep its official policy rate constant. A rate cut between the normal scheduled meetings of its Governing Council may well be more than the ECB can swallow, even though it would make sense.
A coordinated rate cut, agreed at the G7 meetings next Friday, October 10, between the ECB, the Bank of England, the Fed and the Bank of Japan might, however, provide a face-saving way out. The Bank of England could cut by 25 basis points on its own this Thursday, and a further 25 basis points as part of a coordinated rate cut next Monday. The Fed has very little interest rate powder left, unless it is prepared to tax currency and impose negative short nominal interest rates. It should probably not cut by more than 25 basis points – or 50 basis points if a few more significant US banks fail. The Bank of Japan has only 25 basis points to play with. They should play with it now. The ECB should cut by 50 basis points. A demonstration that the ECB is not an oil tanker that takes forever to change course, but instead a nimble frigate that changes course swiftly when the logic of changing circumstances demands it, would be most welcome.