Nobel winner asks bankers to go easy on rate cuts

Philippine Daily Inquirer, February 8, 2008

A VISITING NOBEL LAUREATE FOR economics has cautioned central bankers against using interest rates to perk up stock markets in times of financial turmoil, saying that the US Federal Reserve's recent emergency rate cut was a "very bad" yardstick.

"Banks perform a very important function intermediating between savers and investors. If that function is disturbed, it will be like throwing sand into an otherwise well-performing machine and it could be part of what's going on in this mortgage financial crisis," said economist Finn Erling Kydland during a dinner hosted by the Bangko Sentral ng Pilipinas Wednesday night.

The 2004 Nobel Prize winner, who is in town for a series of dialogues facilitated by the Vienna-based International Peace Foundation, said the credit squeeze arising from the mortgage subprime crisis in the US had, in turn, prompted Wall Street to speculate on the Crisis.

"Probably they will go back and forth in their estimation of the future impact of this shock, which can lead to pretty dramatic fluctuations in the valuation of what these stocks are entitled to," he said.

Kydland thus said he was "a bit disturbed" that the US Fed slashed its benchmark interest rate by a hefty 75 basis points a week ahead of its Jan. 30 regular meeting (during which the rate was cut further to 3 percent).

"It sounds like they're trying to save the stock market. What business does the Federal Reserve have, in trying to save the stock market?” said the Norwegian economist who teaches at the University of California in Santa Barbara and Carnegie Mellon University in Pittsburgh.

Kydland made his comments in response to a question posed by BSP Governor Amando Tetangco Jr.

Tetangco sought Kydland's insights into the central banks' role in resolving issues, such as the adverse impact of the US subprime crisis on the financial markets and the real estate sector.

Kydland said it was inevitable that the US Fed would lower its targeted funds rate-or the rate at which US banks lend to each other-because the central bank had to align its benchmark rate to the prevailing short-term market interest rates.

But instead of waiting for the regular meeting, Kydland said the Fed decided on a 75-basis-point emergency cut, apparently to stop the stock market's freefall"

Kydland said some of his fellow economists were likewise critical of the Fed's move, worried that it would raise US inflation expectations.

The economist said there wasn't much that the central bank could do to ease the financial volatility arising from the US subprime crisis, or rising delinquency among mortgage borrowers with blemished credit histories and little equity.

"For the central bank to do much, it would have to do something that would affect future earnings potential by businesses,” Kydland said.