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It's All about the Credit Markets
By: Dr. Charles Lieberman
Date: 12/15/2008
Policymakers have turned their focus on getting the credit markets working again, which is critical to getting the economy back on track. Lowering interest rates, as the Fed will likely do by 50 basis points this week, is only part of the answer. It is more important to get financial markets working again. Some progress has been achieved so far, but far more needs to be accomplished on numerous fronts. Expect the Fed to pick up purchases of mortgages and other assets to unfreeze credit markets, as it engages in quantitative easing.
The exceptional weakening of the economy can be traced to the failure of Lehman and the takeover of the GSEs in September. Risk spreads exploded in response, as lenders and investors became unwilling to buy whole categories of assets. Stock prices plunged as a record pace, people pulled capital out of money funds, commercial paper issuance fell off dramatically despite the rise in cash coming of out equities, the municipal market froze, and bond issues stopped.
Consumers and business responded by sharply curtailing discretionary spending. That's when car sales plunged by 40%, while outlays for jewelry, furniture, vacations and other big ticket items were also curtailed quite suddenly. Business cut back on planned capital spending and implemented cost saving layoffs, causing unemployment to surge.
Policymakers are trying to turn it all with sizeable capital infusions directly into some of the frozen markets. The announcement the Fed would buy mortgages pushed mortgage rates down nearly 50 basis points within a few days. Libor rates are falling, albeit slowly. The commercial paper market has improved for A1/P1 rated firms, but spreads remain high for A2/P2 credits. Bond issuance has surged for financial firms now issuing FDIC-backed bonds, but it is improving more slowly for other firms. One high-yield issue came to market, but at a cost that will not readily encourage other firms to follow. The municipal market might be open for the highest quality credits, but California is having difficulty raising money. All of these problems and others must be overcome for confidence to recover and households and firms to resume spending.
The Fed will lower rates this week, but that's only a small part of the turnaround. Restoring confidence in the markets is critical. So, expect more direct capital infusions, including one for the auto industry, which will be followed by a large fiscal stimulus package early next year.
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