Indecision Rules the Debate

Posted February 06, 2009

The European Central Bank held rates at 2.0% after much debate. The UK pound strengthened against the US dollar after the Bank of England reduced the benchmark interest rate to 1.0% and the US fails to reach agreement to date on a new stimulus package.

 

The European Central Bank was said to have held a "profound debate", and what that indicates is the continued indecision about what it will take to reverse recessionary trends.  Right now there are two primary strategies being used: lower interest rates and increase government spending.  Both have now been done several times over and yet the economic news gets worse and worse. 

The ECB had an intense discussion as to whether the benchmark interest rate should be lowered, and if so, by how much.  In the end, the bank decided to leave the interest rate unchanged.  The difficult decisions the ECB faced is reflected in the following quote by Julian Callow who is the European economist at Barclays Capital: "The council is having difficulty forming a consensus on the end-game for interest rates."

Both the Bank of England and the US Federal Reserve have cut interest rates close to zero and yet the recession in both countries continues to deepen.  Obviously it is going to take a lot more than interest rate reductions to bring about a reversal of recessionary factors.  The euro strengthened against the dollar though to $1.2791 US dollars per euro, because the joblessness numbers in the US show a 16-year high for January 2009.  But the euro weakened against the yen to 116.33 yen per euro. The US dollar is expected to come under pressure as Congress debates a second round of stimulus programs while the recession continues to deepen. 

The US dollar weakened against the yen to 90.82 yen per dollar.  It also weakened against the UK pound to $1.4613  The Bank of England reduced its benchmark interest rate to 1%. The eyes of the world are on the US Senate which is debating how stimulus spending should be structured.  If or when a package gets close to passing, US stocks will certainly rebound through a diversion of investor funds out of safe haven currency investments into higher risk assets.  But the prediction is that risk appetite will not be sustained because the global economies remain in precarious condition. 

The Mexican peso has been under intense pressure recently forcing Mexico's central bank to sell US dollars in the foreign exchange market for two days in a row in an attempt to bolster the peso's value.  The US recession is leading to a recession in Mexico and the peso has weakened by almost 25% against the US dollar in the last 5 months.  The Mexican economy is contracting and could see as much as a 1.8% decline in 2009.

Weak currencies increase import prices and lead to inflationary pressures.

The currency markets are still quiet right now.  This is largely due to the fact investors are still taking a wait-and-see approach to investing.  There is so much uncertainty in financial markets because this is an economic crisis of proportions never seen before.  The US is having second thoughts about creating a "bad bank", because moving toxic assets to a government bank will still not correct the fundamental problems.

There is no doubt now the effects of the current recession will be felt for many years.  The US decided to offer 7 year Treasury notes again in a sign the government needs more money.  The current stimulus package being discussed in the Senate is growing with each day it is debated.  It began at $800 billion and currently stands at $920 billion.  

So will another trillion dollars in US government spending turn the country's economy around?  The sad answer is: no one really knows.

 

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