Monday, 20 August 2007

Spike in credit spread a risk to economy

The Federal Reserve cut its discount by 50 basis points to 5.75 percent rate on Friday. That act sent markets around the world rallying as investors gained hope that the financial turmoil of the past few weeks may be coming to an end. But was the action by the Federal Reserve justified?

At its meeting on 7 August, the Federal Open Market Committee had chosen to leave interest rates unchanged, stating that its "predominant policy concern remains the risk that inflation will fail to moderate as expected".

However, over the next one and a half week or so, financial markets deteriorated further. Overnight interbank rates spiked on the back of spreading concerns over credit quality, forcing the Federal Reserve and other central banks, especially the European Central Bank, to inject funds to keep rates at their target levels and avoid a credit crunch. This culminated in the Federal Reserve action on Friday.

This raises the obvious question: Was the cut in the discount rate by the Federal Reserve really necessary? How badly is the United States economy likely to be affected by the deterioration in the credit markets?

The answer is less obvious. James Hamilton at Econbrowser points out that an economic downturn is usually associated with a big increase in the spread between corporate and Treasury yields. However, although this spread spiked substantially last week, "the current spread of 206 basis points is not much above the long-term average or the short-term range we've seen over the last two years".

However, apart from the absolute level of the spread between corporate and Treasury yields, the change over a given period also matters, in my opinion. The chart below shows the year-on-year change in real gross domestic product as well as the change in the spread between the Baa corporate bond yield and the 10-year Treasury yield.

The chart confirms that spikes in the spread have in the past often been associated with deterioration in economic growth (note that the spread is shown on a reverse scale in the chart).

More importantly, the chart also shows that although the absolute level of the spread is still low, it may still potentially prove too much for the economy. Economic growth had taken off from around 2003 on the back of declining corporate bond yields and yield spreads. When bond yields and spreads levelled off in 2005, the growth rate turned down soon after.

This suggests that even a small rise in the spread could be associated with some damage in the economy. Therefore, some action on the part of the Federal Reserve to stem the financial turmoil appears warranted.

The next question in most people's minds is whether the Federal Reserve will take another step to bring relief to the financial system by cutting the federal funds rate. After all, the last time a similar spike in the spread was not followed by an economic downturn was in 1998, when the Federal Reserve responded with a cut in the federal funds rate.

Some think that this time around, the cut in the discount rate reduces the need for a cut in the federal funds rate. They are mindful of the fact that Federal Reserve officials have repeatedly said that they would like to see lower inflation become entrenched first and would not now want to be seen as being soft on inflation nor too willing to bail out investors as such an impression risks sparking higher inflation in the future.

On the other hand, others think that deterioration in the credit market is a serious threat to the financial system and an economy that is already facing falling consumer spending. Therefore, a rate cut is necessary to avoid a recession, and it is only a matter of time before it becomes apparent to the Federal Reserve.

In my opinion, both views have merit. It will be interesting to see how the Federal Reserve actually reacts.

In the meantime, other central banks appear relatively unperturbed by the financial turmoil. Over the past two weeks, the central banks of Australia, Chile, South Korea, Norway all raised interest rates by 25 basis points while South Africa's central bank raised rates by 50 basis points.

This week, we have another heavyweight central bank deciding on interest rates: Japan. Expectations for a rate hike by the Bank of Japan at the meeting on 23 August have fallen recently after the latest bout of financial turbulence. However, Governor Toshihiko Fukui has repeatedly said that he wants to normalise interest rates in Japan, so it may be only a matter of time before it hikes rates.

That is quite a contrast with the situation with the Federal Reserve.

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