Gloom deepens as bank losses mount

David Kern

The gap between inter-bank rates and policy interest rates, a key index of
liquidity shortages, is much lower than in the early stages of the credit crisis
as central banks have succeeded in boosting liquidity. The bad news is that the
crisis has moved to a new and more dangerous phase. Citigroup and Merrilll Lynch
have announced huge losses and there are fears over the strength of the banking
system and the wider effects of the global credit crisis. Bank capital has
become a vital, scarce resource. New capital injected by Chinese and Middle
Eastern investors is helpful, but confidence has fallen in the face of worsening
recession fears.

US jobs rose only 18,000 in December, while falling retail sales and
relentless housing weakness add to the gloom. Other figures signal a US slowdown
­ not a recession ­ but the alarm bells are sufficiently shrill to force the
Administration and Congress towards a package of tax cuts. The Fed is supporting
fiscal stimulus and is signalling further aggressive easing. Having already cut
its key interest rate by 100 basis points since August (from 5.25% to 4.25%),
the Fed announced on 22 January an emergency 75 basis points cut, to 3.50%.
Further US rate cuts, to 3%, are expected later in 2008.

Rates Pressures for interest rate cuts are also building up outside the US,
but the pace is more relaxed, because recession fears are less acute and
inflation concerns have higher priority. The Bank of England has kept Bank Rate
at 5.50%. A cut to 5.25% is widely expected early in February, followed by a cut
to 5% by May. The futures market signals further UK cuts to 4.25% or 4.50%, but,
given sterling’s weakness and strong price pressures, cuts below 5% are too
dangerous.

In the eurozone, with inflation above target at 3.1%, the ECB maintains a
tough stance. The key ECB rate has been at 4% since June 2007. With growth set
to slow, the ECB would probably cut its key rate to 3.75% by April. On the
currency markets, the US dollar remains under pressure. But sterling is
vulnerable to sharp speculative attacks.