More UK Credit Market Worries (Plus Further Discussion of the Likely Efficacy of Rate Cuts)

The US isn’t the only country facing a nasty inflation/deflation policy dilemma. The Financial Times gives us further detail on the worrisome conditions in the UK money markets, and a story in the Telegraph describes how the UK’s Shadow Monetary Policy Committee is troubled by the unprecedented drop in loans outstanding from August to the end of September (evidently the latest data available).

Also, at the end, on a somewhat related topic is more evidence supporting my skepticism about further Fed rate cuts. They haven’t been effective so far and there is little reason to believe they will staunch the credit crisis.

I’ve excepted a few paragraphs from an excellent article at Hussman Funds’ Weekly Market Comment, which describes how the Fed increases liquidity. Interested parties should read the entire article; it’s a great primer. The article make a point I have stressed before, that the only thing the Fed controls directly is the monetary base, and increasing the monetary base does not assure an increase in money supply, As Paul Krugman has pointed out, the Fed, contrary to popular opinion, increased the monetary base in the Depression. It had no effect because people were pulling money out of banks. Similarly, if monetary velocity collapses because banks and financial intermediaries no longer trust each other, the Fed’s actions will have little to no impact, as has been the case so far. Central banks need restore confidence, and that likely involves finding ways for institutions with minimal bad debt exposures to prove that to the market, so at least a subset of the system can go back to a semblance of normal operations.

Similarly, a good post at by Rich Karlgaard, cites a new report by Bear Stearns economist and “top forecaster” David Malpass, who sees a disconnect between what he calls “massive” extra cash in the banking system versus tightening spreads, which he attributes to a sharp slowdown in monetary velocity. That points to the dreaded “pushing on a string” if not reversed.

He believes the losses to the financial system are overstated (a companion post today gives coutervailing evidence, and I have two other words to add: CDOs and CDS). Despite our difference of opinion, we’ve included his views on that topic as well.

First, from the Financial Times:

European and UK bank lending rates hit levels not seen for several years on Monday as banks sought funds to cover their commitments for the start of 2008 amid a tightening credit squeeze.

Sterling one-month interbank rates spiked more than 60 basis points to their highest since the end of 1998. European one-month rates rose to levels not seen since May 2001. US rates were also abnormally high….

Bob Janjuah, chief credit strategist at RBS, said: “I have never seen things as bad in terms of trading credit. There are lots of people hoping it will get better in January – we are not so sure.”…

Many banks are not prepared to lend as they want to close their books for the year. The Euro Libor and US Libor contracts rolled into the year-end on Thursday and saw similar spikes.

The largest banks will be able to ride out the pressures because they have access to other sources of funding, such as pension funds or corporate clients….

However, a swathe of smaller European mortgage lenders do not have access to these other sources of finance and remain heavily reliant on the interbank market. As a result they are vulnerable to any surges in Libor rates.

From the Telegraph:

The sterling interbank market has collapsed at the fastest rate in modern history, prompting pleas for immediate rate cuts from a chorus of top British economists.

Office for National Statistics data sourced to the Bank of England shows the volume of market loans in the banking system plunged from £640bn at the onset of the credit crunch in August to £249bn by the end of September, suggesting British lenders have been hit even harder than US banks in relative terms….

“This is one hell of a shock to the financial system,” said Professor Tim Congdon, a leading monetarist at the London School of Economics.

“A market that has taken 30 years to build has completely imploded in a matter of months. Lenders have been squeezed savagely. We’ve moved into a different era,” he said……

The hard-hitting comments were contained in the minutes of the Shadow MPC (SMPC), a group of economists who take the pulse of the economy prior to each MPC vote under the aegis of the Institute of Economic Affairs. SMPC member Peter Warburton, from Economic Perspectives, called for a half-point cut, with further easing in the New Year.

“A profoundly deflationary credit downturn has taken hold,” he said. “Recent weeks’ dramatic events have infected urgency into the situation.”

David Smith, a professor at Derby University and chair of the SMPC, defended the Bank’s wait-and-see approach. “The MPC is walking along a narrow and dangerous Alpine ridge in a blinding blizzard. They can’t see anything,” he said. “People assume that the risk is a credit implosion leading to a second Depression, but there is also a serious risk on the other side of the ridge in terms of inflation.

“The British economy was red hot in the third quarter. RPIX inflation is at 3.1pc. If you look at oil prices, commodities or gold, there are many signs this is like the early 1970s,” he said.

“Has the economy suddenly and totally fallen out of bed? We don’t know yet, and it would be dangerous at this stage to bet it has. There is a risk rates will have to go up next year, not down,” he said.

Now, switching gears back to the US, some commentary from the Hussman Funds, “An Irrelevant Fed: Thimbles of Water in a Forest Fire“:

While the entire Treasury yield curve is currently below the Fed Funds rate, it’s clear that this due to a flight-to-safety in Treasuries. The Fed can certainly penalize savers by pressuring deposit rates lower, but it isn’t having a measurable effect on the market-determined interest rates that borrowers actually face. Nor can the Fed significantly affect the solvency of the mortgage market…..

Very simply, the impact of Fed actions is sorely exaggerated. The amount of liquidity that the Fed provides is minuscule in relation to the U.S. banking system, and also in relation to the volume of capital inflows (about $2 billion daily) that the U.S. relies on from foreigners, thanks to our massive fiscal deficits and low savings rate…..

Again, the problem with the U.S. financial system here is not liquidity, but the solvency of mortgage loans and securitized debt. The Fed’s actions are not likely to have material impact on this. To believe otherwise is mindless sheep-like superstition. Do investors really want to bet their financial security on the hope for “Fed liquidity” promised by uninformed analysts who don’t understand monetary policy because they can’t be bothered to look at the data?

From Bear Stearns’ David Malpass via

Extra cash in the global financial system remains massive. The feeling of a credit crunch is coming more from the slowdown in velocity or turnover of money than from a scarcity of liquidity.

We think the losses to the real economy from the credit market problems are being exaggerated in several ways:

–Some estimates of the size of the sub-prime damages appear to us to be double-counting the losses. The losses in SIVs seem to us to be exaggerated. The issue for the economic outlook is primarily the underlying economic loss. The chain of financial losses are timing decisions in which some are realizing their losses in zero-sum financial calculations, while others will realize gains later.

–We think the still-large net real estate gains over the last decade, by adding to household net worth, act as a cushion against a recession. While the decline in house prices is being treated as a purely negative development, we note that much of the realized losses will be born by sturdy corporate balance sheets; the house price reductions add to housing affordability; the price declines act as a transfer of value from older, more well-off homeowners to younger, less well-off home buyers. Housing weakness has been underway for over two years, with little impact on consumption–we think consumption is more related to the labor environment, not wealth or wealth distribution.

Print Friendly, PDF & Email


  1. E. Cartman


    Interesting points, as usual.

    Do you think that, maybe, the Fed is just propping up every weak-handed player? And thus reducing overall confidence in the system, the precise opposite of what should be done?

    The UK seems to be having a massive private contraction, probably not a shock to anybody who watched the Northern Rock imbroglio unfold. It’s not clear to me that the US is facing the same situation.

    I am also coming around to the idea that Bernanke is simply inflating away the “global savings glut,” using this crisis as his opportunity to cut early and often, to correct imbalances which he perceives (correctly imho) to be unsustainable. But the stresses are already popping up elsewhere, from soaring Chinese inflation to lurching-apart spreads of European government bonds over bunds.

    Comments? ;-)

  2. Anonymous

    ” the only thing the Fed controls directly is the monetary base “

    A more accurate and relevant categorization is that only measure of liquidity the Fed controls is the monetary base. Moreover, it doesn’t control the full monetary base. It only has absolute control over the level of excess bank reserves. It really has no direct control over the demand for currency from the public, to which it responds with a completely elastic supply function that it automatically funds as part of a growing monetary base over time.

    Of greater relevance though is that the primary ‘thing’ or objective that the Fed controls is the level of the fed funds rate (trend, ex daily volatility) through the effect of its monetary base operations (open market, etc.).

    Control of the funds rate is really the only operational reason the Fed has an interest in controlling the level of excess reserves.

    The critical question is whether changes in the fed funds target rate from here will have an effect on monetary velocity and the use of ‘liquidity’ by banks. This is quite a different question than whether existing liquidity is being deployed effectively at the current funds rate (it isn’t), which greatly confuses the debate on the ‘pushing on a string’ issue.

    Anyway, congratulations for being a member of an elite group of commentators that has some appreciation of the technical meaning of liquidity provided by the Fed. At least 99 % don’t.

  3. Yves Smith

    e. cartman,

    I hope to get to your question later today, so bear with me. I have gotten very wound up about Paulson and am working on a post on the subprime rescue plan.

    Anon of 4:03 AM,

    Thanks for your kind words. Yes, I neglected to mention the Fed funds rate, and should have included it, particularly since it was negative real rates in the US that fueled our housing bubble. I am so tired of the focus on whether or not the Fed will cut that I wanted to put the focus elsewhere. But that doesn’t excuse at least an acknowledgment of the role of the Fed funds rate.

    But it is fair to question, as you did, to what extent Fed fund rate changes are effective. 17 rate increases did little to stem the frothy lending and also has comparatively little impact on slowing growth ex-housing.

    And in these circumstances, I am in the Nouriel Roubini camp. He pointed out that the current crisis is one of lack of transparency and insolvency. It isn’t clear at all that rate cuts will ameliorate the problems at hand. I wish the powers that be were thinking of regulatory solutions that would increase transparency. That might take more time to implement, but this crisis has been in motion now since August with little in the way of relief.

Comments are closed.