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Credit spreads unmoved by easy money

S. Balakrishnan

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It could have hardly come at a worse time. Just as Western economies are in descent mode, inflation is rising.

Earlier, it was only headline inflation which flashed red. The US Fed could console itself that, stripped of food and energy (the so-called ‘core’ rate), inflation was within its 2 per cent ceiling. But the latest CPI and Personal Consumption Expenditure (PCE) index shows core inflation beating the cap.

Is ‘stagflation’ (the combination of no growth and rising prices) then setting in?

It is a challenge for the best economic minds — except that there is no assured growth maximising, inflation minimising solution.

‘Risk of recession’

The Fed Chairman, Mr Ben Bernanke, admits it is the case. In his latest testimonies and speeches, he only says the risk of a recession is far more than that of inflation. Unsurprisingly, it provides the justification for more interest rate cuts.

Mr Bernanke has enough and more data to support his line on a rapidly deteriorating economic situation. Not one statistic in recent weeks is positive.

The majority of the Federal Open Market Committee (FOMC), which decides US interest rates, concurs and hence voted in favour of the sharp rate easing actions.

Significantly, bank lending, a potential source of inflationary pressures, has not picked up as banks’ capital are stressed because of losses and write-downs and tighter credit standards.

Obviously, therefore, it is the pass-through of the run-up in energy and commodity prices which has pushed up the price index.

While the Fed Funds rate has fallen to 3 per cent, it has not percolated to any great extent to the market.

Both inter-bank rates and credit spreads continue to be much higher than in normal times. The prices of credit default swaps (CDSs) assume never-before-seen, catastrophic rates of default on bonds.

Hence, critical to the success of the Fed’s strategy is the narrowing of credit risk premiums and a halt to the interminable slide in house prices. In fact, one will lead to the other.

Tricky situation

The trick is to attain a state in which interest rates are so low that house prices look cheap.

For some years now, there is a raging controversy on rising asset prices and how they affect economies and financial markets — a sort of what is good, bad and ugly about them. The Fed’s view, from the time of its previous Chairman, Mr Alan Greenspan, was that central banks should not try to ‘manage’ asset prices — but must act (i.e., cut interest rates) if they crash.

It has clearly done so now. The whole world is watching with bated breath to see if this succeeds in promoting an asset price-led recovery.

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