David Kern

The massive increase in state control, by a pro-capitalist US administration, has provided limited relief only to the financial system. Lehman Brothers has filed for bankruptcy and Merrill Lynch is being taken over. Other major players are under threat. It would be wrong to assume that all the potential casualties would be bailed out.

Rescuing Fannie and Freddie increases the risk of fiscal profligacy, with negative longer-term implications for the credit rating of US government debt and inflation. But the move reduces the threat of a slump, at a time when recession remains a more severe risk than higher inflation.

With oil prices falling sharply since mid-July, to a level below $100/barrel, and with Chinese inflation falling, there are realistic hopes that inflation in the US and Europe would peak in the next two to three months. This would make it easier for the major central banks to cut interest rates.

Rates
Expectations have changed most dramatically in the US. Following stronger-than-expected second quarter US growth, which contrasted sharply with outright GDP falls in Japan and the eurozone, the markets started to predict increases in the Fed funds rate. But, with the US unemployment rate rising in August to a five-year high and with house prices continuing to fall, earlier optimism has given way to renewed concerns that US prospects would worsen. Consequently, many analysts are now predicting an early cut in the US Fed funds rate to 1.75%.

The European Central Bank continues to maintain a hard line. But an early shift towards an easier stance is likely, given the realistic possibility that eurozone GDP will fall again in the third quarter and push the economy into technical recession. We expect a cut in the key interest rate to 4% in the next three to four months.

The UK is also moving towards an early cut in rates to 4.75%. While sterling’s weakness causes problems, the UK economy’s weakness will probably force policy easing.

Currency
In the currency market, the dollar remains strong. Though prospects have worsened, US growth is set to be stronger than in the eurozone and Japan. At least temporarily, the dollar is again a surprising safe haven.