Free money in sight as banks race to zero rate
November 9, 2008
By Simon Kennedy and Craig Torres
Thursday's cuts by the Bank of England and the European Central Bank (ECB), which came with the Federal Reserve and Bank of Japan on the cusp of zero rates, are a bid to shock life back into their recessionary economies and strained money markets. It may be an uphill battle as consumers and businesses show greater interest in saving than spending, and banks hoard capital rather than lend it.
"It's the race to zero," said Stewart Robertson, an economist at Aviva Investors in London. "There's no obstacle to more rate cuts."
The UK central bank, led by governor Mervyn King, on Thursday axed its benchmark rate to 3 percent, the lowest level since 1955. The reduction of 1.5 percentage points was the biggest in 16 years. The ECB followed with its second half-point cut in a month, to 3.25 percent, and bank president Jean-Claude Trichet declined to rule out further moves south for the euro zone.
The action in Europe, which extended to rate reductions in the Czech Republic, Switzerland and Denmark, followed decisions last week by the Fed to drop its key rate to 1 percent, matching the lowest in half a century.
The Bank of Japan made a cut to 0.3 percent in its first paring in seven years. South Korea's central bank on Friday cut its benchmark for a third time in a month.
Monetary policy is being eased because the 15-month credit crisis is inflicting harsher blows to growth and inflation than central bankers anticipated just two months ago.
On Thursday the International Monetary Fund cut its month-old forecast for next year's global expansion to 2.2 percent from 3 percent, and predicted the first contraction in advanced economies since the institution was created in 1945.
It estimated prices would rise just 1.4 percent in rich nations, less than half of this year's pace.
The conundrum for central banks is their rate cuts may still not be packing a punch, even on top of record injections of cash and a willingness to accept lower-rated collateral for their loans.
One reason is that credit markets remain fragile, indicating financial institutions are still conserving cash. The London interbank offered rate (Libor) for three-month loans in dollars fell to 2.39 percent on Thursday from 4.82 percent on October 10.
The record drop still leaves Libor 139 basis points above the Fed's benchmark, compared with an average of 22 basis points in the five years before the global credit crisis began in August last year.
"The problems in money markets are still quite severe," said Dario Perkins, an economist at ABN Amro in London. "Market rates are above where central banks have their rates, and that's alarming them."
At the same time, companies and consumers are retrenching in the face of slowing growth and tighter credit. In the US, Cisco Systems, the top maker of computer networking equipment, is forecasting the first revenue drop in five years because of the financial crisis. Across the Atlantic, ArcelorMittal, the top steel maker, this week said diminished demand was forcing it to double production cuts.
Vehicle makers and retailers are among the firms being battered by a collapse in consumer demand. In Japan, Toyota Motor on Thursday forecast the biggest drop in profit in at least 18 years. Macy's, Target and Gap all posted October sales declines in the US.
Another complication for central banks is that some financial institutions are proving averse to passing on lower rates to borrowers.
By the end of the day on Thursday HSBC, Barclays and HBOS had no yet decided whether to follow the Bank of England's rate cut by paring their own standard variable rates.
The combination of cautious banks and reluctant spenders is forcing central banks to cut interest rates below inflation. JPMorgan Chase calculates borrowing costs adjusted for underlying inflation in developed markets fell below zero last month for the first time since the early 1980s and are still declining.
Central banks are betting that negative real interest rates will induce people to spend rather than save money that is declining in value. The strategy also aims to jolt investors and banks into seeking higher yields by making riskier long-term loans.
As rates fall further, central banks will have to consider less conventional steps to cushion their economies. Among them: making a public commitment to keep rates low; and lowering long-term borrowing by pumping large amounts of cash into banks with direct purchases of government securities.
The debate over the next step could begin as soon as December 16, when Fed policy makers next meet.
As Stuart Thomson at Resolution Investment Management said: "We've got a global deflationary environment now and central banks will have to respond."
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