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Developed nations' group urges U.S. interest rate cut

Section: Daily Dispatches

By Ambrose Evans-Pritchard
The Telegraph, London
Thursday, September 6, 2007

The OECD club of rich nations has called on the US Federal Reserve to cut interest rates to stave off a credit crunch, warning that the sub-prime crisis could trigger a serious global downturn.

"Downside risks have become more ominous. What we had not forecast was the extent of the spread of this financial risk beyond the US," said chief economist Jean-Philippe Cotis. The OECD downgraded its US growth forecast for 2007 from 2.1 to 1.9 percent and refused to rule out a full-blown recession.

"The housing sector is set to exert a longer and more potent than expected drag, and confidence has weakened in the US," Cotis said. "There may be a case for some easing in the US federal funds target rate. There's still the risk of a credit crunch."

The OECD was caught off guard by the credit turmoil, which has spread quickly from US sub-prime across the entire gamut of commercial paper and low-grade debt.

Eurozone data yesterday showed that Germany is so far resisting well, but the Latin bloc has begun to see a marked slide in service growth -- widening the rift between the two halves of the European Monetary Union.

Italy's service optimism index has fallen to a six-year low, and Spain's has dropped to a five-year low. Spanish unemployment jumped by 58,000 in August as the building industry cut payrolls, starting a political firestorm.

Finance minister Pedro Solbes said the country faced "much more uncertainty than a month ago" but insisted that Madrid had "sufficient instruments" to cope with the crisis despite having no control over interest rates.

Shares in Spain's construction giant Sacyr fell 5.8 percent yesterday after it admitted that the property boom was "unsustainable."

House prices have vaulted 270 percent since 1995, fuelled by negative real interest rates until 2006. The bubble has now burst. Prices have dropped 2.1 percent in both Madrid and Barcelona so far this year, according to Preciometro. Mortgage payments in Spain are priced off floating Euribor rates, which have jumped 80 basis points above the European Central Bank's key rate of 4 percent.

Eric Chaney, an economist at Morgan Stanley, said Spain was the most vulnerable country in Europe to any credit crunch, citing private sector debt of 185 percent of GDP.

"Should credit standards tighten significantly, Spain could be hit by a double whammy, since both corporations and households look overindebted," he said.

Banks on both sides of the Atlantic continued to hoard cash yesterday, pushing up the three-month dollar Libor for the 10th day in a row to 5.72 percent, the highest level since the onset of the dotcom bust in early 2001.

The spike has caused further mayhem for the $2 trillion commercial paper market, which is based on Libor and has imploded by 11 percent over the last three weeks.

Chris Greener, a credit expert at Societe Generale, said parts of the market were frozen. "Either they can't roll over the paper or they're not willing to pay these punitive spreads," he said.

Almost no deals went through the corporate credit markets yesterday. BNP Paribas said investors were waiting to see whether banks can offload some $300 billion of debt still stuck on their books from leveraged buyout deals.

"The next couple of weeks will show if and at what price investors are willing to swallow those risks. A substantial rewidening of the corporate bond and swap spreads is likely," it said.

Stephen Lewis, global strategist at Insinger de Beaufort, said the emergency injections of liquidity by central banks had yet to unfreeze the credit markets.

"If money market counterparties distrust each other so much they are not willing to take on exposures, the panoply of instruments available to a central bank will be powerless to restore smooth functioning of the market," he said.

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