Three steps have been required to staunch the credit crisis. The first was greater government willingness to buy risky assets and in some cases take stakes in troubled banks. This is now being done. The second is to keep the world’s financial infrastructure intact through the provision of ample liquidity. Ditto. That left the third step – a sharp drop in interest rates. This was finally met on Wednesday, with a co-ordinated 50 basis point cut by the Federal Reserve, Bank of England, European Central Bank, Canada and Sweden (and 25bp cuts by Switzerland and 27bp by China too).

Real rates

To date, the biggest obstacle to these cuts has been central bank fears about inflation. In the UK, for example, inflation is more than twice the 2 per cent target. Yet inflationary threats are falling everywhere. Commodity prices – for energy and food – have dropped. Real wages are falling and unemployment is on the rise. Finally, goods inventories are rising – in Germany, France, Korea, and China – while global demand is collapsing. In short, inflationary pressures are fast receding.

The aim of the rate cuts is to help stop recession turning into depression. But how? They are not meant to encourage borrowers to perpetuate the credit boom. Nor will cuts, of themselves, unblock the world’s clogged money markets. What they will do is generate a positively-sloped yield curve on government bonds. Crucially, this will help banks recapitalise themselves as they borrow at the short end, lend to governments at longer maturities, and pocket the spread. This, in turn, will boost bank demand for government bonds, which is just as well given that the need to finance growing budget deficits will be huge.

Normally, rate cuts, combined with unbridled fiscal spending, are a sure route to inflation. But not in this case, or at least not for the foreseeable future. In fact, real interest rates have risen steadily since the start of the year, as can be seen in the rise in yields on inflation-indexed bonds. On that basis, the rate cuts were overdue. More are likely to come.

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