Monday, October 06, 2008

Compression, cont.

G20 interest rates cuts to near zero % is gaining "intellectual" steam now. A nice trial balloon. However, rate cuts alone will not stimulate aggregate demand enough. A Fiscal response is needed. Japan and especially the U.S. have the most license to accomplish this.

"So the case for interest rate cuts both in the euro area and the UK are strong indeed now, not because of any non-specific confidence effects or because this will help the solvency of their bankings sectors. While lower official policy rates do indeed permit banks to recapitalise themselves (provided the yield-curve is upward-sloping), the timing and scale of such official-policy-rate-led recapitalisation are such as to make it relevant to the resolution of the current crisis. Lower rates are required because an unexpected weakening of the real economy (caused by the collapse of the banking system) has increased the downside risks to inflation.

By how much and when should the Bank of England and the ECB cut their official policy rates? For both I would consider a 50 basis points immediate cut to be appropriate. When is immediately? For the Bank of England, this should be at the next regular rate setting meeting, on Thursday October 9. The ECB just met last week and decided to keep its official policy rate constant. A rate cut between the normal scheduled meetings of its Governing Council may well be more than the ECB can swallow, even though it would make sense."

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