Financial markets almost holding central bankers to ransom

Central bankers across the world on Wednesday cut interest rates in a coordinated response to contain the financial turmoil that has gripped global markets with the hope of preventing a global economic meltdown. The US Federal Reserve Bank, the Bank of England, the European Central Bank and central banks from China, Canada, Australia, Sweden and Switzerland slashed their interest rates in order to add some liquidity to the markets.

It is rather fascinating that the US inflation rate as on August 31 2008 was at 5,37%, the highest in 17 years, and that did not deter the Federal Reserve Bank from cutting rates. US economic growth rate had slowed to 2,2% and is anticipated to slow even further. Similarly, the inflation rate in the United Kingdom was at 4,7%, an 11-year high, and the economy had grown by a dismal 0,2% in Q2 2008. Signs of doom could not be ignored.

The Bank of England has a mandate to ensure price and financial stability. What this means is that the bank, in terms of its mandate, has to contain inflation by employing interest rates to control liquidity in the market. In terms of financial stability, the Bank of England is concerned with the soundness of the financial system, and this is where regulation comes in.

The glaring difference between the mandate of the Bank of England and that of the Federal Reserve is that while the Fed is also concerned with price stability, it is also tasked with ensuring full employment in the economy, simply translated to mean growth in the economy. The Fed, however, use two interest-rate levers to influence the level of liquidity in the market.

Firstly there is the discount rate — the rate charged to commercial banks on loans they receive from their regional Federal Reserve Bank through the discount window (a lending facility). Secondly there is the federal funds rate, which is the rate at which banks lend their balances placed with the Federal Reserve to other banks overnight.

A shift in the federal funds rate would ordinarily affect the liquidity in the market by affecting other short-term and long-term interest rates, foreign exchange rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and prices of goods and services. This dual mandate allows the Fed to focus on one goal or the other as conditions demand and to balance policy effects, and it is for this reason that the Fed reduces rates despite a spiralling inflation rate.

What is mind-boggling is the action taken by the Bank of England and other central banks with the sole mandate of maintaining price stability to slash interest rates in the face of an ever-increasing inflation rate. The effects would temporarily boost sentiment in volatile markets, prop up liquidity and hopefully jump-start the economy, but inflation may as a result still continue to rise. These central bankers have thrown caution to the wind in responding to the demands of the financial markets. Nothing vaguely guarantees that the drop in commodity prices, which are the biggest contributors to inflation, is sustainable and that inflationary pressures will be subdued.

The cause of inflation for most global economies in recent times has been largely supply shocks, for example the rise in oil prices, and for some a combination of both supply and demand shocks, due to unrestrained consumption spending as we saw in the US when times were good and consumers were chasing the American dream.

John Maynard Keynes believed that increased consumption during periods of economic recession serve to strengthen the economy. The Chairman of the Fed, Ben Bernanke, confirmed that its decision to cut rates was inspired by the overwhelming pressure to resuscitate consumption spending. Bernanke noted that the pace of economic activity has slowed considerably and the intensifying financial turmoil is exerting additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit — hence the decision to drop rates and get nervous consumers and businesses to spend more.

The problem here is that real interest rates, the difference between the inflation rate and nominal interest rate, are further squeezed, leaving no motivation for savings or investing in low-yielding securities like bonds. This only serves to increase volatility in the markets as investors opt to invest in high-yielding assets such as shares where returns are expected to be significantly in excess of inflation.

In the US, real interest rates have already turned dramatically negative, a glaring sign of loss of confidence in the economy and that inflation is getting out of control. The US inflation rate is at about 5,37% and the discount rate has been slashed to 4,5%, hence the over-exuberance in the stock markets.

Although commodity prices are declining due to the slowdown in global economic growth and the strengthening of the dollar against major currencies, inflation has not shown any signs of a decline. It thus looks highly unlikely that the monetary policy committee of our South African Reserve Bank will cut interest rates. Tito Mboweni appears to take his mandate extremely seriously.

Our inflation rate has been escalating in recent quarters and now remains at 13,6%, without any signs of abating. Our economy is not immediately facing challenges similar to those that confront developed economies. It would be premature for the Reserve Bank to cut rates on Thursday. Should that occur, it would be an indication of paranoia on the part of the monetary policy committee, but nevertheless a welcome false step in policy direction.