Ambrose Evans-Pritchard: Inflation-busting Bernanke won't rush to relieve the pain

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By Ambrose Evans-Pritchard
The Telegraph, London
Saturday, August 11, 2007

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/08/11/ccom11...

Nobody understands the threat of a credit crunch better than Ben Bernanke, the chairman of the US Federal Reserve.

The soft-spoken professor made his name at Princeton studying how mayhem in the banking system can lead to economic slumps, where he published his famous tract: "Inside the Black Box: the Credit Channel of Monetary Policy Transmission."

So far he has kept a cool nerve, ignoring a growing chorus of traders, bankers, and pundits on Wall Street pleading for swift action to prevent the sub-prime mortgage debacle spreading through the US economy.

CNBC commentator Jim Cramer caught the mood of mounting anguish with his trademark hyperbole: "It is no time to be an academic. Open the darn Fed window. Bernanke has no idea how bad it is out there. The Fed is asleep," he said.

On this side of the Atlantic, the European Central Bank has responded to the crunch with startling speed, opening its credit window to "unlimited" tenders on Thursday after the interbank lending system came close to freezing up.

It provided E95 billion (£64 billion) to the banks in the biggest one-day injection of liquidity since the launch of the euro, adding a further E61 billion yesterday -- though on a more restricted basis.

Jean-Michel Six, Europe economist for Standard & Poor's, said the ECB may have overreacted. "It is true that we have a genuine crisis in confidence," he said. "The credit markets have been getting tighter and tighter, and nobody is ready to lend to anybody. But the exposure of European banks to US sub-prime is fairly limited and most of it is the good-quality 'AAA' and 'AA' tranches.

"By taking this action the ECB is suggesting that they know something that nobody else knows, and that there is more to come. It may take the markets a few weeks to overcome these suspicions," he said.

The ECB has had to contend with the failure of Germany's IKB bank, bailed out to the tune of E8.1 billion by the German state last week.

Even so, the epicentre of this crisis is in the US, where American Home Mortgage -- the 10th biggest home loan lender -- has just filed for bankruptcy, the latest of 110 lenders to close its doors since late 2006.

Yet the Federal Reserve has been almost parsimonious, adding just $24 billion (£12 billion) of extra liquidity on Thursday.

When this failed to stop the federal funds rate rocketing overnight to 6 percent, it stepped in again yesterday with $35 billion and a calming statement that it would do all it could to "facilitate the orderly functioning of financial markets."

About time too, said Ed Yardeni, president of Yardeni Research. "I think they will have to cut rates, and probably before their scheduled September meeting," he said.

Critics of the Bernanke Fed hark back to the quick response of Alan Greenspan when the markets seized up after Russia's default in 1998 and Long Term Capital Management (LTCM) began to implode, caught in a bond squeeze with $100 billion of positions.

Interest rates were cut at an emergency session, keeping the economy on track for another two years' growth.

Nouriel Roubini, an economics professor at New York University, warns that this episode may be even more dangerous than the LTCM bust.

"The current market turmoil is much worse than the liquidity crisis in 1998. Today we have an insolvency/debt crisis among a variety of people who borrowed excessively during the boom phase of the credit bubble," he said.

Distressed debtors have been able to put off the day of reckoning until now by borrowing ever more, but the credit tap has at last been cut off.

Gabriel Stein, an economist at Lombard Street Research, doubts whether Mr Bernanke will oblige with easy money.

"Greenspan was a serial bubble blower who never saw a rate cut he didn't like, but Bernanke wants to curb inflation and wring the excesses out of the system. We're looking at a very different kind of Fed," he said.

Julian Jessop, from Capital Economics, said there was no need yet for central banks to start slashing rates.

"It may not feel like it looking at screens, but the current market turmoil is not yet serious enough to justify a fundamental rethink of the economic outlook," he said.

"Policy-makers have been warning for some time that markets had become complacent about risk.

"Now that these warnings are being proved right, central banks will not want to signal that they are always ready to bail out the markets," he said.

Teun Draaisma, European equity chief at Morgan Stanley, who issued a "triple sell signal" with uncanny accuracy on the day the markets peaked, believes the current storm will blow over.

"This a bull market correction but the confusion may last a while longer.

"Whole parts of the credit markets are shut down and big banks are having to close funds that were supposed to be as safe as houses," he said.

"We're getting to levels where stocks look attractive, but don't jump in yet."

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