The credit markets in the U.S.A., Asia, and Europe are in the midst of a freeze at the moment. Banks are not willing to lend to each other hence the big hike in the Euribor (European inter bank ordinary rate: this is the rate that banks lend to each other at) rates and in the U.K. the Libor (London inter bank ordinary rate) rates, they are trading much higher than the central bank rates and this indicates that there is (to a degree) a general mistrust between banks, mainly because they don’t know the exposure to sub-prime exposure the other may have.
The response thus far has been a Fed rate cut, this came a little late, and the indication is that Ben Bernanke will cut the rates again within the next week. Earlier in the year (March 28th) Bernanke claimed that ‘the impact on the broader economy & financial markets of the problems in the sub-prime market are likely to be contained’. Later in June he again re-iterated that there was not a strong chance of a spill-over into the wider economy. This is clearly not the case. Hence the emergency liquidity injections that have taken place along with the coming rate cuts.
The credit freeze is not likely to clear any time soon, if the ECB (European Central Bank) cut rates it may alleviate things a little but probably not enough as their main function is to control inflation and any rate cut would likely result in increased inflation. The Bank of England meanwhile lives in a parallel universe, while they talk about inflation, they are bailing out some lenders and others are on the verge of collapse.
Housing is in a bear market across many markets, and that along with a widespread credit crunch means that there is a genuine risk of deflation, personally I have faith in the ECB but that doesn’t mean everything will automatically turn out o.k.. The effect of a rate cut at this point is almost academic fortune telling because there has been such a massive influx of liquidity to the market, over half a trillion worldwide since august.
However, a rate cut by the ECB would likely help in several areas, firstly it would give a big influx of liquidity, restore confidence in credit markets and reduce the euros position versus the dollar as it is currently trading at an all time high. This may mean the ECB taking a position where inflation is not the governing decision maker. Time will tell….