Last week’s financial market rioting sent a strong message to the Fed and other central banks that policymakers cannot wait to see spillover effects of tighter credit conditions on the economy. Quality spreads have soared and bid/ask spreads have blown out around the world. In Europe, it is alarming that interbank dealing in covered bonds came to a halt last week and planned high-quality debt issuance was cancelled. Measures of banking sector risk have exploded and liquidity in interbank money markets is deteriorating again. Interbank lending is the main channel through which central banks affect financial markets and the economy. Policymakers cannot allow these markets to stay moribund for long because it might mean that interest rate cuts become impotent. Bottom line: The Fed needs to cut interest rates promptly, and pressure is building on other central banks to follow suit.
http://www.bankcreditanalyst.com/public/index.asp

For what it’s worth.

The Treasury prices have dropped considerably along the yield curve due to flight to quality. I don’t have the stats, but it is a virtual certainty that spreads have widened on the long end as they have on the short end.

Even Paul Krugman, hardly the sort that sits in front of a Bloomberg terminal, has taken note. Here is a current version from David Merkel at Seeking Alpha:

The FOMC can loosen interest rate policy, but how much will unsecured interbank lending rates like LIBOR respond? As it stands right now, the Treasury-Eurodollar spread [TED spread], is at 180 basis points, up from 96 basis points (or so — don’t have access to a Bloomberg Terminal). 17 basis points of that rise is a rise in LIBOR. That’s not the usual response that you expect to loosening monetary policy, but these are unusual times, when credit spreads dominate over monetary policy, even on high quality lending and short term.

Paul,

Agreed that is why the Fed communicates the way it does (look what happened to poor Mervyn King, the governor general of the Bank of England, when he very clearly said he believed in moral hazard and then along with the Treasury and FSA, bailed out Northern Rock? Much crow-eating ensued).

The real problem is the Fed isn’t as independent as we like to think. I believe it was Willem Buiter who said the Fed was the one of the least independent central banks, second only to the Bank of Japan. If it was more secure in its position, it could be more straightforward.

Nevertheless, the Fed’s failure to communicate to the markets points out the need for other strategies, or perhaps different “voices” for different messages.

Peter Pan,

That is a good strategy. Let’s hope that’s what the Fed does. The folks who are lobbying for further cuts have not focused sufficiently on how destabilizing they would be for the dollar and commerce. You can’t plan when currencies are this volatile. And there is also the not-trivial risk of a run on the dollar.

If the market tanks then the Fed can make an emergency rate cut at the quarters ending options expiration the following week. Friday the 21st is just before a Christmas holiday weekend and market participation will be very thin that day. A rate cut could have maximum effect for that day.

Peter Pan

Is the dense verbage of the Fed not CYA language? It seems to me that the Fed is most worried about being wrong and getting the blame for bad moves. If the public cannot understand the Fed’s motives they cannot assign blame.

If my salary and reputation depended upon the performance of the economy over which I had little real control, I’d speak as much nonsense as the public let me get away with (witness Greenspan). Only a true crisis of confidence in central banking would produce a central banker who would relate to the pubic in understandable ideas. We’re not there (yet?).

Thanks,
Paul

A rate cut isn’t about the economy; it’s about who on the Titanic gets a seat on the lifeboat. Cutting rates = GS and friends get the front row seats.