Losing Control Of Monetary Policy

In the US Merrill forecasts gloom for US economy.

US interest rates will plunge from 4.5pc to 2pc as the American economy suffers its first consumer recession since 1991, Merrill Lynch has forecast. The investment bank warned in its annual economic outlook that America is under attack by the "Four Horsemen" of soaring energy prices, unemployment, a housing slump and an ongoing credit squeeze, but it remained optimistic about prospects for the rest of the world in 2008. The one significant exception to this global "rebalancing" is Britain where a "notable slowdown" is predicted.

Merrill Lynch's North America economist David Rosenberg presented an almost unremittingly gloomy forecast for the US economy next year. "The US consumer is on the precipice of experiencing its first recessionary phase since 1991 - the last time we had the combination of high, punishing energy prices; weakening employment conditions; real estate deflation and tightening credit conditions" he said.

"We reiterate that real estate deflations are unique and have never ended well for the consumer, the credit market or the economy. We can identify only five periods post WWII when the real value of housing assets turned negative on a year-on-year basis. All of these time periods inevitably included a consumer downturn. Maybe it will be different this time, but we fail to see why," Mr Rosenberg concluded.

Rosenberg is certainly on the right side of the fence on most issues and has been for some time. But I have to question the idea that the EU decouples. Property bubbles bursting in Spain and France and tight money policies by the ECB are going to add to the complications.

Be Prepared For A Wave of US Bank Failures

Furthermore, if there is a rush of bank failures in the US as I expect, see Wave of Bank Failures is Coming, I doubt that many global economies are spared a substantial slowdown.

In the UK the Market fears the BOE has 'lost control'.

There were fears in the City last night that the Bank of England has lost control of monetary policy after expectations for money market borrowing costs rose - despite the Monetary Policy Committee cutting interest rates. Short sterling futures, which indicate where the market expects the key benchmark interbank borrowing rate to be in two weeks' time, actually rose markedly after the Bank's decision - an almost unprecedented reaction.

John Wraith of Royal Bank of Scotland said: "Historically, a 25-basis point change in Bank rate would lead to an almost identical change in Libor. That hasn't happened."He said this made it highly likely that the Bank would eventually be forced to cut rates even further than anticipated.

Peter Spencer, chief economic adviser to the Ernst & Young Item Club, said: "The fact of the matter is that the market rather than the Bank is now dictating monetary policy - and not from the point of view of controlling inflation, but from the point of view of a random walk. It is behaving in a way which is totally rational for individual banks but adds up to a major deflationary issue.

Corporate Bond Contraction in the EU

The Bank for International Settlements reveals that a full scale shutdown of corporate bonds as companies in the UK have cut back on their borrowing at the fastest rate in over three years.

In Germany, Europe's biggest economy and the world's biggest exporter, businesses paid back more than they borrowed for the first time since the 1980s. The value of bonds issued by businesses in the international debt markets halved between the second and third quarters of the year.

In Germany, whose banks have been some of the biggest victims of the sub-prime mortgage crisis in the US, some $20bn more was paid back than borrowed.

ECB Hawks Focus On Inflation

In the EU, ECB hawks snub pleas for rate cut.

Jean Claude-Trichet, the ECB president, caught analysts off guard and rattled the European bond markets by revealing that the ECB's arch-hawks had pressed for a rise in interest rates to choke off mounting inflation. The 19-member council voted to keep rates steady at 4pc, reportedly after an exchange of hot words.

Julian Callow, eurozone economist at Barclays Capital, accused the ECB of "sabre-rattling". "The idea of a rate rise is so out of line with opinion in the markets that it won't happen. Spreads on three-month Euribor rates - used to price mortgages in parts of the eurozone - jumped by 93 basis points over ECB rates yesterday, the highest since the credit crunch began in August. It is equivalent to almost four rate rises.

My Comment: This is a serious situation. While I understand the concerns, hiking into a credit crunch, is not likely to work well. Rising oil prices are not a cause of inflation. However, one must understand the sentiment at play. The Bernanke Fed like the Greenspan Fed are overrun by fears of the great depression, while the EU harbors distant memories of the Weimar Republic hyperinflation.

"Trichet's remarks can't be taken seriously," said Jörg Krämer, an economist at Commerzbank. The reality is that the ECB has cut its growth forecast for next year from 2.3pc to 2pc and expects inflation to fall back to 1.8pc by 2009.

My Comment: Trichet is trying to adopt a wait and see attitude. But if oil spikes up on a supply shock or a geopolitical shock in the Mid-east, it would be a major policy mistake to hike into that.

Lombard Street Research said Spain in particular is now in serious trouble, with a "staggering" current account deficit of 9pc of GDP and a huge overhang of unsold property from the housing bubble. "Spanish financial imbalances are amongst the most severe in the developed world," it said.Lehman Brothers, Goldman Sachs and Morgan Stanley have slashed their eurozone forecasts, abandoning the idea that Europe will be able to "decouple" from America.

My Comment: In light of the above, Europe is not going to "decouple" from America. Either David Rosenberg at Merrill Lynch has a blind spot or he quickly changes his tune. I expect the latter.

Summary Recap

• The US is on the precipice of its first consumer led recession since 1991.
• A wave of US Bank failures is coming.
• LIBOR rates are rising in the US and UK smack in the face of interest rate reductions.
• The ECB continues with hawkish rhetoric.
• German businesses paid back more than they borrowed for the first time since the 1980s.
• Three-month Euribor rates are 93 basis points over ECB rates.
• One-month LIBOR rates are 74 basis points over the Fed Funds Rate.

The Fed and BOE easing actions simply are not working to restore faith in the credit markets. Credit conditions based on LIBOR are worse now than in the August and November stock market swoons. Banks remain reluctant to lend to one another in spite of central bank efforts to provide liquidity. Neither central bank appears to be in control of anything at the moment. Of course it was only an illusion that made it seem like central bankers ever were in control in the first place.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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