Zero-interest world may lie ahead


By Simon Kennedy and Craig Torres
Bloomberg News
Friday, November 7, 2008

The age of free money may be at hand.

As major central banks slash interest rates with unexpected speed, benchmark borrowing costs are now below core inflation for the first time since the early 1980s, and policy makers are signaling they will go deeper.

Yesterday's cuts by the Bank of England and European Central Bank, 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 Ltd. in London, which manages about $230 billion. "There's no obstacle to more rate cuts."

The U.K. central bank led by Governor Mervyn King yesterday 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 President Jean-Claude Trichet declined to rule out further moves south.

The action in Europe, which extended to 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 a half-century, and the Bank of Japan to cut to 0.3 percent in its first paring in seven years. The central bank of South Korea today cut its benchmark for a third time in a month.

... Harsher Blows

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. Yesterday 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 it 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 that 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: Credit markets remain fragile, indicating that financial institutions are still conserving cash after recording losses and writedowns of about $691 billion. The London interbank offered rate for three-month loans fell to 2.29 percent today from 4.82 percent on Oct. 10. The record drop still leaves Libor 129 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 2007.

... Problems 'Severe'

"The problems in money markets are still quite severe," said Dario Perkins, an economist at ABN Amro Holding NV in London. "Market rates are above where central banks have their rates, and that's alarming them."

Credit standards for loans to companies tightened "significantly" in the third quarter and will probably tighten again in the current quarter, the Frankfurt-based ECB said in its quarterly bank lending survey.

At the same time, companies and consumers are retrenching in the face of slowing growth and tighter credit. In the U.S., Cisco Systems Inc., the top maker of networking equipment, is forecasting the first revenue drop in five years because of the financial crisis. Across the Atlantic, Luxembourg-based ArcelorMittal, the world's biggest steelmaker, this week said diminished demand is forcing it to double production cuts.

... Companies Retrenching

Automakers and retailers are among the companies being battered by a collapse in consumer demand. In Japan, Toyota Motor Corp., the world's second-largest, yesterday forecast the biggest drop in profit in at least 18 years. Macy's Inc., Target Corp. and Gap Inc. all posted October sales declines in the U.S.

U.S. payrolls shrank by 240,000 workers last month, the Labor Department said today, taking the two-month decline to the biggest since 2001. The jobless rate rose to 6.5 percent, the highest in 14 years.

Another complication for central banks is that some financial institutions are proving averse to passing on lower rates to borrowers. HSBC Holdings Plc, Barclays Plc and HBOS Plc are among U.K. mortgage lenders that have still to decide whether to follow the Bank of England's rate cut by paring their own standard variable rates. In the euro area, banks yesterday deposited a record 297.4 billion euros overnight with the ECB rather than lend it elsewhere.

"We expect the banking sector to make its contribution to restore confidence," Trichet said yesterday.

... Cautious Banks

The combination of cautious banks and reluctant spenders is forcing central banks to cut interest rates below inflation. JPMorgan Chase & Co. calculates that 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, economists said. The strategy also aims to jolt investors and banks into seeking higher yields by making riskier long-term loans.

"It's clear you need to have interest rates that are lower than inflation going forward," said Jan Amrit Poser, chief economist at Bank Sarasin in Zurich. "Central banks are rushing to get interest rates down."

... 'Too Early'

Still, it's "far too early" to talk about zero interest rates throughout the industrial world, given inflation expectations remain positive, says Jim O'Neill, chief economist at Goldman Sachs Group Inc. in London.

"People should be wary of rushing to shift the debate from inflation to deflation," he said.

Rapid rate cuts are intended to avoid the fate of Japan, which endured a decade-long slump after its asset bubble burst in 1990 in part because its central bank was "initially too timid and too slow to react," economists at Deutsche Bank AG said in a report yesterday.

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 what comes next could begin at the Fed as soon as Dec. 16, when policy makers next meet amid expectations for another quarter-point cut.

"We've got a global deflationary environment now and central banks will have to respond," said Stuart Thomson, who helps oversee $46 billion in bonds at Resolution Investment Management.

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