December 21, 2007

The Fed is facing a dilemma. Today’s numbers on personal income and spending were relatively strong—clearly inconsistent with any recessionary scenario that the market is toying with. And even more problematic for the Fed is that the inflation numbers continue to trend upward—limiting the Fed’s maneuvering room.

But if the Fed moves again (and we believe it will) the main trigger would be the credit crunch and its potential implications for the economy in general, and the financial system in particular. On this front, the first $20 billion of term auction facility (TAF) provided by the Fed this week—giving 8,000 depositary institutions access to fresh liquidity without the stigma of having to use the Fed’s discount window—were well received, with the final rate on the auction ending up higher than anticipated. This means that financial institutions are eager to get this money. Another $20 billion auction will take place in January 2008.

But injection of funds is not the ultimate solution. The crisis is not really of liquidity, but mainly of trust among financial institutions with regard to potential exposure to subprime credit. To clear this problem, the market needs more than just cash. It needs information. And this information can be obtained only when there is a clear sense of the market price of those subprime-linked securities. In this context, the TAF system can provide some sense of the market value of this securities since under the TAF mechanism, the Fed can accept as a collateral some subprime backed assets—and for that you need to establish the value of this securities—a value that can
be used by the market as a benchmark. So the TAF system might provide more than liquidity. It potentially can start a process of providing the market with some badly needed information.

President Bush’s plan to freeze interest rate reset on subprime borrowers is not a bad idea and it should help a significant enough number of borrowers to make some difference. We estimate that roughly 370,000 borrowers will be able to avoid reset between January 2008 and July 2010—that’s not bad  In Canada, things are clearly slowing but not at an alarming pace. The economy is roughly half a percentage point below its speed limit—more or less where the Bank of Canada wants it to be given the inflation environment. However, we still expect the Bank to cut again in January 2008—just to provide additional liquidly to the market.

Benjamin Tal
Senior Economist