Going Over a Cliff

Benjamin Ong at The Financial Standard reports:

Taking lessons from the past, a shock response from the world's major central banks in the form of big interest rates reductions - in the order of say 50-100 basis points each time - might assist reducing the magnitude and length of the coming recession, if not a 1930s-style depression.

The RBA may indeed cut interest rates by 50 basis points today. In turn, we might eventually see the US Federal Reserve adopt the BoJ's policy of zero percent interest rates. The Reserve Bank of Australia (RBA) will have a lot to digest when its Board meets today to deliberate on the country's monetary policy setting. However, the RBA has only one critical decision to make - by how much does it need to CUT interest rates.

Barely three days (including the weekend) after the US enacted its rescue package, Europe is, itself, trying to fend off the impact of the credit squeeze. Last night, Germany announced plans to insure all private deposit accounts; the European Central Bank decided to loosen its securities quality rules to facilitate the bailout of German firm Hypo Real Estate; the government's of Belgium and Luxembourg sold their respective 75 per cent and 67 per cent share of Fortis' assets to BNP Paribas; to shore up its capital ratio, Italian bank UniCredit asked its shareholders for 3 billion euros and ‘implemented a series of cost-cutting measures, and the execution of other extraordinary transactions currently underway or envisaged.'

All these are happening against the backdrop of a worldwide slowdown that has steadily gained traction.

The problem here is that the current credit crunch had sparked a mutually reinforcing chain reaction of cutbacks by excessively leveraged borrowers and loss-ridden lenders. This is different from the crunches of the 1970s when all that was needed were short-lived adjustments to cool accelerating inflation. This time, a longer-term process of deleveraging is needed.

This is more akin to the traditional debt deflation processes seen before the second World War. These kinds of finance-driven downturns were difficult to get out of - as the US Treasury and the Fed have now learnt.

Certainly the package will help reliquify banks and other financial institutions, but with investors now dumping their stocks and earnings decelerating, banks would still need to cut back their lending and sell more assets to increase their capital-asset ratios. The way things are, banks now could sell their assets to the government. Banks would not need any help cutting back on their lending as well. Consumers and corporations are already reducing their demand for loans - debt deflation.

There really is no easy way out at this point in time. The looming global recession must run its course in order to purge the system of its past excesses.

Taking lessons from the past, a shock response from the world's major central banks in the form of big interest rates reductions - in the order of say 50-100 basis points each time - might assist reducing the magnitude and length of the coming recession, if not a 1930s-style depression.

The problem this time is that while the RBA and some other major central banks still have scope to lower interest rates, benchmark rates at the world's two biggest central banks - the US Federal Reserve and the Bank of Japan - are already close to the floor. The fed funds target rate is at 2 per cent and the BoJ discount rate is at 0.5 per cent.

The RBA may indeed cut interest rates by 50 basis points today. In turn, we might eventually see the US Federal Reserve adopt the BoJ's policy of zero percent interest rates.

John Frayer at Bloomberg reports Deflation Threat Returns:

As Federal Reserve Chairman Ben S. Bernanke and his global colleagues fight the worst financial crisis since the 1930s, one danger is looming larger by the day: deflation.

With asset markets tumbling, commodity prices plunging the most in 50 years and banks keeping a tighter grip on credit, the ingredients for a sustained period of falling prices are coalescing.

A global recession is already looking more likely, with the credit freeze stirring memories of Japan's decade-long struggle with deflation in the 1990s. So European Central Bank President Jean-Claude Trichet and Bank of England Governor Mervyn King may be forced to follow Bernanke, whose Fed has chopped its benchmark rate by 3.25 percentage points since August 2007 to 2 percent -- its most aggressive round of easing in two decades.

The deflation scenario might go like this: Banks worldwide, stung by $588 billion in writedowns related to toxic assets -- especially mortgage-related securities -- will further reduce the flow of credit, strangling growth. That will push house prices lower, forcing additional losses and making banks even more reluctant to lend. As the credit crisis worsens, businesses will find it almost impossible to raise prices.

Aggressive Easing

Trichet said Oct. 2 that European policy makers have considered reversing their decision in July to raise their benchmark rate by a quarter point to 4.25 percent. Forty-six of the 61 economists surveyed by Bloomberg News expect the Bank of England to cut its key rate by at least a quarter point Oct. 9 from 5 percent.

The Fed has already responded to one deflationary scare this decade. With inflation approaching 1 percent in 2003, then- Chairman Alan Greenspan slashed its rate to a 45-year low of 1 percent and kept it there for a year, which its critics say helped fuel the property and credit boom that is now unraveling.

Former Fed Governor Lyle Gramley says that while deflation is a risk ``if we were to go into a very, very prolonged recession and nobody did anything about it,'' he is ``not worried,'' because he's confident the Fed will act ``very, very, very aggressively.''

Deflationary Consequences

``The risk we must be careful not to underestimate is the deflationary consequences of the credit crisis,'' Bank of England Deputy Governor John Gieve said last month.

In the U.S., prices manufacturers paid for materials last month plunged the most since at least 1948, with the Institute for Supply Management's index dropping 23.5 points to 53.5 points.

The breakeven rate on U.S. 10-year Treasuries, a measure of price expectations, dropped to 1.4 percent from 2.6 percent in July. Japan is the only country whose bond market implies a lower inflation rate than the U.S. The rate represents the pace of inflation investors expect over the life of the securities.

All this is likely to make the Fed resume rate cuts, says Robert Dye, a senior economist at PNC Financial Services Group in Pittsburgh, Pennsylvania.

``If we're going over a cliff, we're not going to go over a cliff with a 2 percent federal funds rate,'' he says. ``What's the point of holding back?''

PIMCO Urges Fed:

Bill Gross, head of the world's largest bond fund, on Monday urged the U.S. Federal Reserve to take more dramatic steps to jump-start paralyzed credit markets, including direct purchases of commercial paper.

"A systemic delevering likely requires a systemic solution, which moves beyond cyclical interest rate cuts, liquidity provisions, or even the purchase of subprime mortgage-backed bonds," Gross, chief investment officer at Pacific Investment Management Co, wrote in his October letter to investors released Monday afternoon.

Gross, who oversees more than $812 billion in assets at Pimco, said the Fed must make the bold step of outright purchasing of commercial paper.

Furthermore, the Fed must now act as a "clearing house," guaranteeing that institutional transactions are cleared and counterparty obligations are honored, Gross said.

Interest rate cuts are also in order, Gross said.

"They should also cut interest rates to 1 percent, because we are experiencing asset deflation, and the threat of headline inflation is long past," Gross said.

The Dow Jones industrials .DJI settled Monday below 10,000 -- the first time since October 2004 -- down 369.88 points.