As markets get nervous, will central banks keep their composure?

Markets saw more volatility last week and many investors are now calling for central banks to cut interest rates to prevent a financial crisis. The calls are unlikely to be heeded for now though.

In fact, some central banks are still looking to raise interest rates.

The European Central Bank met last week and decided not to raise interest rates for the moment. However, at the press briefing after the decision was announced on 2 August, President Jean-Claude Trichet said that the "existence of upside risks to price stability at medium to longer-term horizons is confirmed by the strength of the underlying rate of monetary expansion" and that "strong vigilance is therefore of the essence", suggesting a rate hike is likely at the next meeting.

The indication of another rate hike was given despite an acknowledgement that financial markets were experiencing a period of nervousness. Trichet called the episode a "re-appreciation of risks" and "a phenomenon of normalisation of risk pricing". While he said that the central bank would "pay great attention to the developments in the market", he also said that the authorities would "keep their composure" and "permit the evolution of the market to be as effective as possible in terms of going back to a normal assessment of risks in general".

On the whole, it does not look as though the ECB is particularly concerned about the current turmoil in financial markets. In fact, more than a few analysts have even suggested that it welcomes it as a means of reining in excess liquidity.

Next week, the focus shifts to the Federal Reserve as the Federal Open Market Committee meets to decide on interest rates. No change is expected at this coming meeting. It seems likely to me that the Federal Reserve will follow in the ECB's footsteps, that is, acknowledge the developments in financial markets but not make substantial adjustment to its monetary stance.

Fed funds futures, though, show that rates are widely expected to be cut before the end of the year. Many investors think such a cut would be necessary to save the economy from what is perceived to be a developing credit crunch spreading from the mortgage market in the United States.

The Federal Reserve, however, will probably feel constrained from acting too soon. While it is likely to be more sensitive to the on-going turmoil in financial markets than the ECB because the market nervousness is centred on the US credit market and affects US financial institutions directly, the Fed's primary focus is ultimately on the effect of interest rates on inflation, not on the effect on financial markets. It would also be aware that, in addressing the risk to the financial system from the market turmoil, it risks creating a moral hazard by bailing out investors and, worse, aggravating inflation in the process.

Nevertheless, based on recent economic data, there is indeed hope for a rate cut later in the year to a large extent because the fear of renewed inflationary pressure is likely to continue to recede.

On Friday, the Labor Department reported that nonfarm payrolls increased by 92,000 in July, the smallest since February, while the unemployment rate rose to 4.6 percent, up from 4.5 percent in June. As the labour market weakens, inflationary pressure is likely to weaken as well.

In addition, the acceleration in US economic growth in the second quarter appears over for now. The Institute for Supply Management's indices for both manufacturing and non-manufacturing declined in July, the manufacturing index falling to 53.8 from 56.0 in June and the non-manufacturing index falling to 55.8 from 60.7.

Moderate economic growth and gradually rising unemployment should help keep inflation in check. As it is, all the main measures of core inflation in the US are now turning down, with the personal consumption expenditures price index excluding food and energy in June rising 1.9 percent from the previous year, a rate of increase that is within what is generally considered the Fed's comfort zone.


Having said that, other measures of core inflation remain above 2 percent. The consumer price index less food and energy rose 2.2 percent year-on-year in June, the Cleveland Fed's 16-percent trimmed mean CPI rose 2.6 percent and the Dallas Fed's trimmed mean PCE inflation rate was 2.3 percent.

And with oil prices maintaining an upward trend in recent months, the Federal Reserve will probably want to stay vigilant on inflation.

Therefore, while the probability of a rate cut by the Fed before the end of the year has clearly risen, unless we see a more sustained deterioration in credit markets, I think the Federal Reserve will prove to be less eager for a rate cut than many investors hope or think.

And perhaps that is the cue for investors concerned about the possibility of a credit crunch to take matters into their own hands, join in the "evolution of the market" and re-price risk accordingly.