Tracking Recent Changes in Financial Market Stress
The current financial market stress has been through various stages of severity since the crisis began to unfold in August 2007. The Fed has reduced the federal funds rate to 1.00% from 5.25% beginning September 18, 2007 and set up numerous facilities to provide liquidity and maintain financial market stability.
The volatility of the federal funds rate (see chart 2) has been significant throughout the period since the crisis commenced. The severity of volatility of the federal funds rate has been most pronounced in terms of magnitude and duration since September 15, 2008. The largest standard deviation was on September 30 (195 bps) and it has come down noticeably in the past few days.
The announcement of a new regime where reserves, both required and excess, are paid interest appears to have reduced volatility. There have been three different computations regarding the interest rate that will be paid for reserves (10/6/08, 10/22/08, 11/05/08). The latest announcement pegs interest on reserves at the target federal funds rate excluding situations when the target rate has been changed during the reserve maintenance period. The sharp increase in excess serves is an important factor (see chart 2) that has led to the jump in volatility.
The spread between the 3-month Libor and the 3-month Treasury bill rate has narrowed to 194 bps as of November 10 and it is about 199 bps as of this writing.
At the long and risky end, the situation has not improved, with the spread between high yield bonds and the 10-year Treasury note yield at 15% (see chart 4).
Despite the support from the Commercial Paper Funding Facility, the commercial paper market continues to experience stress. The spread between 3-month commercial paper and 3-month Treasury bill rate is around 225 bps, still at an elevated level (see chart 5), but off the highs seen in late-September 2008 and mid-October. On October 15, 2008, this spread was 200 bps and as of November 7, 2008 it was 110 bps.
Financial institutions have borrowed record amounts from the different facilities at the Fed (see chart 6). Against this background of uncertain and unstable financial market conditions, economic reports from the real economy send a message of severely weak economic conditions.
Bank of England Forecasts Worsening Recession
The Bank of England’s Quarterly Inflation Report was released this morning and its outlook for the UK economy was every bit as dismal as feared. The Bank’s central projections for GDP growth and inflation are "substantially weaker" than in the August Report, although today’s Report also acknowledges that the prospects for both are "unusually uncertain." The central projection is for a pronounced contraction in domestic demand that causes output to fall markedly through the first half of 2009, with the contraction in real GDP reaching around 2.0% on the year by Q2. Assuming a combination of lower interest rates, a gradual expansion in credit, lower global commodity prices, a weaker currency, and continued fiscal stimulus, a gradual recovery should get underway in the second half of next year, with real GDP growth nudging back into positive territory by Q1 2010.
The annual rate of inflation is projected to fall sharply in the near term, down from 5.2% in September to around 2.0% by Q2 next year, and then "well below the 2.0% target" by mid-2010. The Report also noted that most measures of inflation expectations have fallen back in recent months. This year’s previous Reports had highlighted the possibility of rising inflation expectations as a key risk to the inflation outlook.
All told, the BoE’s projections are its most pessimistic in over a decade and are significantly worse than just three months ago. Back in August, the BoE’s central projection saw the economy bottoming out in Q2 2009 with real GDP growth around zero y-o-y, and inflation not falling below the target rate until early 2011.
In his subsequent press conference, BoE Governor Mervyn King noted that there will be "much to learn between now and our next meeting" but also stated that "we are certainly prepared to cut the Bank rate again, if that proves to be necessary."
This morning also brought the release of September employment data. The number of unemployed (EU-harmonized ILO measure) jumped to 1.825 million in the three months to September, the highest level since October-December 1997, pushing the unemployment rate up to 5.8%, the highest rate since January-March 2000. The number of people claiming unemployment benefit ("claimant count unemployment") jumped by 36,500 in October, the sharpest increase since December 1992.
The minutes of last week’s Monetary Policy Committee meeting will be published November 19, and will give an indication of just how worried the members are about the outlook. However, the tone of today’s Inflation Report, the magnitude of the downward forecast revisions, and the Bank’s acknowledgement that it is no longer so concerned about higher inflation expectations, together point to another marked cut in interest rates at the December 4 policy meeting – 50bps is a given, up to 100bps is possible – and probably more easing in early 2009.
