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Breaking news in the mortgage market

October 8, 2008 at 9:20 AM EDT


OTTAWA — Major central banks took the extraordinary step of deeply cutting interest rates in an emergency co-ordinated move Wednesday, a development that serves to underline the deterioration of the world's banking system and threatened global recession.


Central banks in Canada, the United States, Britain, the European Union, Sweden and Switzerland cut key lending rates by half a percentage point. China's central bank joined others by cutting its key interest rates 27 basis points as of Thursday.


Only Japan, among the major central banks, opted out given that its rates are already at rock bottom.


A co-ordinated rate cut has been the subject of much market chatter over the past couple of weeks as stock markets and commodity prices have plunged, and credit has frozen.


The move came after a sharp overnight drop in Asian markets and U.S. stock futures that threatened to spark another North American selloff Wednesday. The Dow Jones industrial average lost 508 points Tuesday, bringing down markets globally. Britain also was rattled by a deepening banking crisis, forcing the government to announce a $80-billion bailout package.


“The pace of economic activity has slowed markedly in recent months,” the Federal Reserve said. “Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit.”


The move gave some comfort to economists, but they warned the action is not enough to end the deepening financial crisis.


“Today's co-ordinated half-point cuts from all the major central banks ... will provide at least a temporary boost to confidence, but we fear there is still a lot more work to do,” said economists at London-based Capital Economics. “For a start, the fact that the central banks have had to take such extreme measures underlines how bad market conditions have become.”


The Bank of Canada lowered its key rate to 2.5 per cent, from 3 per cent, and tried to assure the public that Canada's banks were still solid.


“The intensification of the global financial crisis is having a marked impact on all countries. In recent weeks conditions in global financial markets have deteriorated sharply, the U.S. economy has weakened further, and commodity prices have fallen abruptly,” the central bank said in a statement it issued alongside a joint statement with other countries.


“As a result of these developments, credit conditions in Canada have tightened significantly, despite the relative health of our financial institutions.”


The central bank warned that the U.S. downturn and weakness among key trading partners is hurting Canada's exports. Plus, the domestic side of the economy is no longer on fire as commodity prices drop and the Canadian dollar slides, the bank noted.


Inflationary pressure is no longer an issue, the central bank said, since demand from Canadian consumers and businesses is no longer strong.


“This action will provide timely and significant support to the Canadian economy,” the bank said.


The joint action on Wednesday does not mean that the Bank of Canada won't consider more rate cuts at its next scheduled decision date on Oct. 21, central bank spokeswoman Jill Vardy said.


“It does not preclude more action on the 21st,” she said.


It's the first time since the terrorist attacks of September 2001 that the world's major central banks have taken a co-ordinated rate cut. The decision to move in concert was made Tuesday afternoon after policy makers agreed that working together would have far more impact on confidence and markets than taking individual measures.


“A co-ordinated reduction helps,” said Ms. Vardy. “It can prove more effective for central banks to act together.”


There may be more in store in Canada this week, aside from the central bank announcements and interventions in credit markets. Conservative Leader Stephen Harper said Tuesday the government has something else in store – although his spokesperson would not elaborate.


“The risk is that 50 basis points wasn't enough, and that none of that will pass through to consumers and businesses as interbank funding pressures continue to worsen even after the rate cut,” said Derek Holt, vice-president of economics at Scotia Capital Inc. “This is not the last of the cuts, and both the Fed and the Bank of Canada could easily cut another 100 basis points.”


Financial institutions in key countries around the world have essentially stopped lending money to each other for fear they won't be paid back. That, along with their need to deal with losses stemming from bad loans, has sparked a major hike in the cost of borrowing. It has also made the availability of money extremely scarce for consumers and businesses.


This credit crunch comes at the same time as the world economy is slowing, led by the United States, where the housing collapse has spread to the rest of the economy.


“I think the markets were assuming something along these lines would happen,” said Douglas Porter, deputy chief economist at BMO Nesbitt Burns in Toronto. “The scope of it is impressive, though. The fact that even China loosely joined in makes this, as far as I'm aware, unprecedented.”


It is a big but appropriate step, Mr. Porter added in an interview, and shows just how far the problem has spread and how serious it is.


However, while the rate cut “can't hurt,” he said, one concerted move by the central banks will not be enough to turn the tide.


“There need to be further moves down the road, and I don't necessarily mean just in rate cuts,” Mr. Porter said, citing the Fed's unprecedented offer Tuesday to step in and start buying commercial paper directly from companies and institutions that sell the short-term debt to finance day-to-day operations.


Still, the BMO economist also criticized central banks for not moving sooner after it became clear the $700-billion (U.S.) bailout package for Wall Street, passed by Congress Friday, was ineffective. “I thought they should have gone Monday, when it was obvious that the initial response to the bailout package wasn't that great,” he said.


The rate cut is just the latest in a long string of novel moves made by central banks in recent weeks. They have repeatedly flooded money markets with fresh cash in the form of short-term loans, and made such cash easier for financial institutions to borrow, by broadening what they will take as collateral.


In the United States, the government put together the rescue plan to sop up toxic assets undermining the stability of key banks. And in Europe, governments are bailing out banks, guaranteeing bank deposits, and talking about stimulus packages.


“Everybody's throwing everything in the tool box at this problem.” said Royal Bank of Canada chief economist Craig Wright. “I don't know that, given how negative sentiment is, any one event would turn it, but the hope is that the culmination of all these events starts at least to get recognized.”


The jury is still out on how much impact the co-ordinated rate cut by the central banks will have on sentiment, Mr. Wright added.


One key gauge, he said, is whether interest rate spreads shrink on interbank lending , particularly the so-called TED spread, the premium paid for three-month euro-dollar deposits over U.S. Treasury bill yields. These spreads have been at or near historic highs, demonstrating banks' extreme unwillingness to lend to each other as the global financial crisis continues.



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