Tuesday, 22 April 2008

As BoE fights credit crunch, is inflation the greater threat?

The Bank of England has come up with its own plan to avert a credit crunch. From Reuters:

The Bank of England detailed a ground-breaking plan on Monday to lend banks around 50 billion pounds to help them operate during the credit squeeze.

It said it would allow banks to swap mortgage-backed bonds which have become hard to trade for specially-issued Treasury bills.

This would free up banks' balance sheets, allowing them to lend more to households facing a dwindling choice of mortgage options and declining property values.

However, in view of the rather severe haircuts that banks using the facility will have to take, it remains to be seen how much banks will actually use it.

In any case, maybe a credit crunch isn't the worst thing to worry about. From Merrill Lynch analysts TJ Bond and Alex Patelis writing at the FT:

[D]omestic bank lending globally has not been significantly affected... [T]he impact of the credit crunch has largely been confined to capital markets...

[C]redit crunch or not, the arguments for strong growth in emerging markets – underinvestment, insufficient infrastructure, favourable balance sheets, rising consumer income and a growing middle class – have not changed. Emerging markets account for more than half of global growth; we expect that share to rise over the next few years...

The risk for policy is that concerns about growth may make central banks hesitant to tighten. Indeed, the big surprise for 2008 so far has been the surge in inflation, not the cut to growth.

Focused on the credit crunch, central banks could miss the message in commodity prices. Especially in emerging markets, the loss of macro stability as inflation becomes entrenched could prove far more damaging than the short-term headwinds from the global credit crunch...

Tim Duy says that even in the US, it may be "time to think about the other side".

[E]conomic downturns do not last forever, and the current episode is no exception. Ever since last summer, the yield curve, particularly the 10-2 steepness, has been sending a signal that I find difficult to ignore – a signal that the technical recession will be rather shallow and short-lived. Indeed, the 10-2 spread currently is consistent with the end rather than the beginning of a downturn...

Bottom Line: I suspect the cessation of rate cuts is near at hand... It will soon be time to turn our attention to timing the next tightening cycle. Expected job market/housing weakness argues for an extended period of low rates similar to the last cycle; continued strength in commodity prices argues for a more rapid reversal of recent policy...

However, John Hussman thinks that the strength in commodities -- key to the proponents of an inflation threat -- is not sustainable.

... I continue to view commodities as cyclical, and decoupling as implausible – indeed, my impression is that the commodity surge will likely be turned on its head within a few months, about the point where 10-year Treasury yields move above the year-over-year CPI inflation rate. Having spent the mid-1980's working at the Chicago Board of Trade, I was always impressed how much more “V-shaped” commodity price charts were than equities or bonds. Spike tops, spike bottoms, and steep reversals are common. Investors overly tied to the commodity boom and “global demand” as drivers of investment positions would do well to examine that behavior. It is often initially painful, but ultimately worthwhile to remember that it's best to panic before everyone else does.

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