The worsening of the US and global liquidity and credit crunch - and the now high risks of a US hard landing that will spread to the rest of the world as recopling replaces decoupling - suggest that all major central should cut policy rates as soon as possible. It is not time to temporize and wishfully hope that the credit crunch will go away; conditions in interbank markets and credit markets are much worse now than they were in the peak of the crisis in August as measured by various Libor spreads relative to policy rate or to same maturity government bond yields; thus, the minimum that central banks should do now is to cut policy rates. 

The Fed has already reduced the Fed Funds rate by 75bps and it will continue to do so in December and January but a more aggressive easing (say 50bps in December rather than the more likely 25bps) is necessary; and the Fed Funds rate will be below 3% by the end of 2008 as a US recession is now inevitable regardless of how fast the Fed eases.
 

Today the Bank of Canada started to get it by, unexpectedly, cutting its policy rate by 25bps; but 25bps is puny given the liquidity crunch in global markets that has also spread to the Canadian markets.  50bps or more was the minimum necessary to deal with a Loonie that is lunatically high and a massive financial contagion from the US to the Canadian financial markets.
 

This week the Bank of England and the ECB will meet to decide on monetary policy and markets are expecting both central banks to stay on hold. Keeping policy rates in the UK and the Eurozome steady now will be a mistake The Sterling Libor rate is literally going through the roof : yesterday the Sterling 1 month Libor spiked more than 60bps from Friday levels to its highest level for 9 years following a similar move in the Euro Libor at the end of last week. Thus, nothing short of a policy rate cut – justified also by the sharp slowdown of economic growth in the UK and the beginning of a housing bust – will make a difference in UK financial markets.  The BoE should start worrying about a likely UK recession as retail sales are faltering, the housing boom is starting to go bust and the pound is too strong.
 

The same holds for the ECB: the ECB has so far deluded itself that the liquidity and credit crunch was a temporary phenomenon and that, once that crunch was eased, it could continue on its policy rate hike campaign. Time to get real euro Libor spread are signaling near panic in Eurozone financial markets: the Eurozone economy risks a serious hard landing as the credit/liquidity crunch is as severe as in the US hurting corporate borrowing and capex spending, the euro is going through the roof and severely hurting export competitiveness, housing bubbles around Europe are deflating, economic activity and demand are slowing, and the US hard landing will hurt Europe’s exports even further. The ECB should avoid the mistake made in 2001-2002 when it eased too little too late with the cost that the European economic downturn was as bad as the US one and the growth recovery is 2002-2005 pathetically dismal.
 

And while at 0.5% policy rates in Japan are still very low the BoJ should get ready to consider the ZIRP (zero interest rate policy) if a US hard landing that will hurt Japan as much as any other country (given the dependence of Japan on next export growth) risks triggering another bout of deflation and near recession in Japan.

Fiddling with marginal injections of liquidity to deal with the liquidity crunch – rather than cutting policy rates – will not work. There is some heated debate now on whether the liquidity crunch is due to: 

a) short-term year end liquidity needs;

b) a more persistent liquidity risk premium;

c) a rise on counterparty risk;

d) a more general increase in risk aversion due to severe credit problems and information asymmetries (risk aversion due to uncertainty about the size of the financial losses and on who is holding the toxic waste of RMBS, CDOs and other ABS products);

e) the failure of the monetary transmission mechanism in a financial system where most financial institutions are now non-bank and thus do not have direct access to the central banks lender of last resort support.

f) all of the above (as it is most likely).
 

What is true is that, regardless of which one of these alternative explanations is right the policy reaction so far of monetary authorities has miserably failed to ease the liquidity crunch: in spite of injections of liquidity of hundreds of billions of dollars by Fed, ECB, BoE, BoJ, BoC; in spite of cuts in discount rates, in spite of significant lengthening of maturities of repo operations; in spite of acceptance of  a wider collateral for such liquidity injections; in spite of some move towards a market-making of last resort (a’ la Buiter proposal) rather than lender of last resort only by central bank the liquidity crunch and credit crunch in G7 financial markets (and the overall Eurozone) are worse now than in August.

So the time for band aid measures and clever but ineffective palliatives is over: only a monetary policy ease could make some difference in reducing the level of interbank rates (if not the interbank spreads) and avoid the sharp tightening in monetary conditions and rise in real short term interest rates that the spike in interbank spreads has created.
 

This author has argued for a while that a Fed easing will not prevent a hard landing as the more fundamental credit problems of the economy will not be resolved by monetary policy alone. That does not mean that policy rates should not be reduced in the US and elsewhere: a US recession will, at this point, occur regardless of how fast the Fed eases but the depth and persistence of such a recession will depend on how aggressive the Fed is. I.e. the Fed will not at this point be able to prevent a recession – for the same reasons why it did not prevent one (in spite of very aggressive easing) in 2001 – but it would be able to put a floor on the depth and length of such a recession.
 

The same holds for all the other major central banks: ECB, BoE, BoC, BoJ. There is now a serious risk of a global economic downturn in 2008 as the US is inevitably headed towards a recession and this recession is leading to economic recoupling across the globe. Given the lags in the effect of monetary policy – 6 to 9 months – the time to cut rates is now. As central banks have remained on hold – with the exception of the Fed and the BoC today – real short rates faced by financial institutions and all sort of other borrowers (as many private financial contracts are linked to Libor)  have gone up by 75 to 125bps in the last few weeks; this is a severe tightening of monetary and credit conditions. Thus, holding nominal policy rates steady means having effectively increased such nominal and real borrowing rates for banks,  financial institutions, corporations and even households (as most revolving consumer credit and ARM style of mortgage products are linked to short rates).
 

So while we should not delude ourselves that cutting policy rates will resolve deep seated credit and insolvency problems among many distressed borrowers – and  resolve fundamental problems in a world of financial innovation, globalization and securitization that require fundamental regulatory reforms - that will take years to resolve, the alternative of not cutting policy rate aggressively is the risk of a global economic recession.
 

The central banks current concerns with a rise in inflation are totally misplaced as a US recession will lead to global disinflation (and concerns about deflation as in 2002-2003) via four channels:

a) a fall in US aggregate demand relative to supply;

b) a slack in labor market conditions and slowdown in wage growth as the unemployment rates sharply increases;

c) a fall in global aggregate demand as the glut of output from overinvestment in China and some other EMs will face a fall in global demand as the world recouples with the US hard landing;

d) a sharp fall in oil, energy, food and other commodities prices as a global slowdown emerges.  We are set for the repeat of the 2000-2003 cycle when the Fed and other central banks underestimated the downside risks to growth and overestimated the upward risks to inflation and ended up having to aggressively cut rates to deal with the fall in economic activity and the deflation risks that such a US and global recession triggered.
 

And it does not make sense to avoid bailing out the real economy – and preventing a massive global loss of incomes and jobs – just in order to punish reckless lenders and investors in the financial market and thus avoid moral hazard. Moral hazard in financial markets is contained via sensible credit policy and appropriate regulation and supervision of financial markets. In times of economic danger bailing out the real economy with monetary easing may have the by-product of partially reducing the financial losses of reckless lenders and investors (an indirect bailout). But the first order costs of a global recession is much larger than the second order costs of partial moral hazard; such moral hazard will be kept in check by hundreds of billions of dollars of losses that will occur regardless of monetary policy easing and via sounder regulation and supervision of financial markets in the future up-cycle of credit.
 

To conclude, as it is obvious to any sane person when your home is on fire it is not   a good time to sit in front of the burining building to discuss the merits of the moral hazard of fire insurance on your incentive to recklessly smoking in bed or debate the additional damage to your home coming from excessive use of fire hoses (the risk of higher inflation down the line). When your home is on fire and there is serious risk of fire contagion to all of your town and beyond you want the entire fire brigade to provide enough liquidity to avoid entire edifice and town burning to the ground.  And using hand-held and hand-carried buckets of water while pondering the intellectual merits of moral hazard of fire insurance in order deal with a major five-alarm fire - rather than using immediately your global fire brigade - is delusional.  So it is time for the international central banks’ liquidity fire brigades to turn on the hoses and dealing with this most dangerous global fire.