The Future of Interest Rates

From Bloomberg Today:

Bernanke, Trichet Urged by Markets to Do Rates U-Turn

Credit markets are telling central banks what to do, and it isn't what Ben S. Bernanke or Jean- Claude Trichet had in mind.

Days after reaffirming their interest-rate stance against inflation, central bankers may be forced to do an about-face. Traders are paring bets on imminent rate increases in Europe and Japan, and some even speculate the Federal Reserve may execute an emergency cut.

Behind the changed outlook is concern that the steps central banks have already taken -- pumping cash into markets over three days to avert a credit collapse -- won't be enough to keep global growth from stalling. In the days before, Fed Chairman Bernanke, 53, and European Central Bank President Trichet, 64, were saying inflation, not financial instability, was the biggest risk.

``The dramatic moves by many of the world's central banks could imply that we have a whole new ball game when it comes to monetary policy,'' says David Brown, chief European economist at Bear Stearns Cos. in London.

Just before last week's turmoil, Trichet signaled the ECB would lift its benchmark rate in September, and Bernanke indicated the Fed had no plans to cut rates. On Aug. 8, Bank of England Governor Mervyn King, 59, said he didn't see ``an international financial crisis;'' investors were merely reappraising risk.

Weakened Positions

Their positions were undermined when fallout from the U.S. subprime crisis spread abroad after BNP Paribas SA, France's largest bank, halted withdrawals from three investment funds because it couldn't value their holdings. The Fed, ECB and other central banks added $154 billion to the banking system on Aug. 9 and $135.7 billion on Aug. 10. The ECB injected $65 billion today. The last similar effort to prevent rising market interest rates from getting out of hand was just after the 2001 terrorist attacks.

As the new week begins, the risk is the extra liquidity won't keep money flowing through the financial system, threatening to push up borrowing costs on everything from mortgage loans to credit cards and hobbling economic expansions. That may force central banks to rethink their monetary policy strategies.

``Such developments indicate substantial stress and central banks don't usually like to compound this by raising policy rates as well,'' said Julian Callow, chief European economist at Barclays Capital in London. ``Actions by the ECB and Fed so far appear only to have been buying time.''

Reduced Expectations

In Europe, investors reduced expectations for higher rates in the U.K. and the 13-nation euro area. Traders see an 80 percent chance the ECB will raise rates in September, down from 90 percent on Aug. 8. They have also abandoned bets, made a month ago, on two rate increases from the Bank of England by the end of the year even though the U.K. has been alone among central banks in the Group of Seven in not pushing liquidity into the market.

The Bank of Japan may be the first to blink when its policy makers convene next week. The chance of the bank's increasing borrowing costs at that meeting was at 32 percent today compared with 75 percent on Aug. 9, according to calculations by Credit Suisse Group.

Federal funds futures indicate investors are betting the Fed will cut its target rate of 5.25 percent by a quarter percentage- point at its Sept. 18 meeting.

``It is not inconceivable that such an easing could occur within days if market conditions continue to deteriorate,'' says Jan Hatzius, chief U.S. economist at Goldman Sachs Group Inc. in New York.

Early Cut

Two-year notes reinforce the idea the Fed will cut borrowing costs before September. The yield on two-year notes, more sensitive to expectations for Fed policy, was at 4.49 percent, or 0.76 percentage point less than the Fed's key rate.

The last time the gap was wider than its level of this month was in 2001, when the central bank, under former Chairman Alan Greenspan, reduced rates 11 times -- to 1.75 percent from 6.50 percent -- to try to pull the economy out of a recession.

That year was also the last time the Fed lowered rates outside a regularly scheduled meeting, which it did three times in 2001. The first, on Jan. 3, came just two weeks after policy makers had changed their view that inflation posed the main threat to the U.S. economy. Subsequent actions came in April and again in September, the latter to shore up consumer and investor confidence following the terrorist attacks that month.

`Faced With a Crisis'

While the Fed hasn't faced such a challenge with Bernanke as chairman, ``there's no reason to be concerned they'll feel hemmed in when faced with a crisis,'' says Brandeis University economics professor Stephen G. Cecchetti, former director of research at the Federal Reserve Bank of New York.

Still, Bernanke isn't under the same pressures to cut rates quickly that Greenspan faced during his career, which spanned the 1987 stock-market crash and the 1998 Asian currency crisis, as well as the terrorist attacks.

``Bernanke is in a little bit better position to make independent decisions without too much pressure from other parts of the government,'' says Scott Pardee, former head of foreign- exchange operations at the New York Fed and now a professor at Middlebury College in Vermont. ``It isn't one of these things where everyone in the world is calling on the Fed to lower interest rates.''

The Fed may have done enough after adding $62 billion to the banking system on Aug. 9 and 10 and pledging further funds as necessary, says Dominic Konstam, head of interest-rate strategy at Credit Suisse in New York. Stocks rallied worldwide today and U.S. index futures advanced, while the ECB said today it's optimistic that ``market conditions are normalizing.''

`Liquidity Issue'

``The Fed is going out of its way not to cut rates to resolve the liquidity issue,'' Konstam says.

A major reason for caution at central banks is the risk that a premature rate cut compromises their effort to contain inflationary pressures stoked by the fastest global growth in three decades. Inflation in China accelerated to the highest rate in more than a decade in July, the National Bureau of Statistics said today.

Charles Goodhart, who sat on the Bank of England's panel between 1997 and 2000, says that's what happened after central banks in Europe and the U.S. cut rates in response to the 1998 currency crisis, only to see inflation accelerate and asset bubbles inflate during the next two years.

``Central banks reduced rates and very quickly wished they hadn't,'' he says. ``The rate decision had to be reversed quite sharply to deal with the major upturn that we saw from 1998 to 2000.''

For now, some economists are loath to make concrete predictions. JPMorgan Chase & Co. says a forecast that 15 of the 31 central banks it covers will raise rates before October depends on ``normal'' market conditions returning.

``We're in a situation where I don't think anyone knows what will happen next,'' says David Mackie, the bank's chief European economist in London.