I was on holiday when the markets crisis broke. Somehow, viewing a crisis through the lens of a wine bottle helps to keep things in perspective. Still, I knew the situation was serious when a French radio news show referred to the drop in equity markets shortly after a reminder it was the 30th anniversary of Elvis's death. Then, I arrived in the office on Monday to be told by a gloomy colleague that the US economy was at a "tipping point".
More seriously, the US "plunge protection team" is back. This mysterious group first appeared in 1987 after the stock market crash. It sealed its reputation during the Clinton administration, steering markets through a series of crises in the 1990s. Now, the Treasury's Hank Paulson and the Fed's Ben Bernanke lead the team. Still, the decision to cut the Fed's discount rate had a Clintonian bent.
Markets have calmed down because they expect the Fed to follow up with a cut in the more important federal funds rate. There is speculation of a half percentage point cut before the Fed next meets in mid-September. So far, the Fed has resisted the cut, for good reason. It has consistently warned that financial markets have been too complacent in pricing risk. Now markets have finally repriced, triggering wider risk premiums and greater volatility. Inevitably, some investors have lost huge sums, but a Fed "bailout" could create a moral hazard: investors might take bigger risks if they know the Fed will cut rates if they run into trouble.
But the continuing slowdown in the US economy is complicating the situation and I think the Fed will have to put aside its concerns and cut its funds rate in the next few months.
The outlook for European interest rates is less clear cut: growth is more resilient in the UK and the euro area. So, I see no scope for cuts and, in the euro area, the ECB might even put rates up.Reuse content