Central Banks Cut Rates: Lifeline or Patch?

Will the rate cut make any difference?

On October 8, 2008, the world’s major central banks coordinated a half-point rate cut. The ECB moved from 4.25% to 3.75%, the Fed cut 50 basis points to 1.5%, and Sweden, China, and Canada joined in. The move, applauded in markets for a few minutes, was quickly met with skepticism: the Paris stock exchange rebounded 0.09% before falling again. The question everyone asked was whether this was a lifebuoy or just a patch.

A stunt that fooled no one

The cut was expected, but the coordination surprised. "Inflationary tensions must have been reduced," some joked, while others pointed out that the Fed had already exhausted that ammunition and that the effect would be limited. The problem was not the price of money, but the lack of money: banks were not lending to each other. The TED spread, an interbank risk indicator, hit a record 4.13% that same day. "Monetary policy isn't working," summarized one analysis.

The euro area borrowing rate, oblivious to the party

For the average citizen, the key variable was the euro area borrowing rate (Euribor). With the ECB’s rate cut, many expected immediate relief on their mortgages. But the Euribor did not move. "The Euribor never falls," they complained. The spread between the official rate and the interbank rate soared to 1.75 points in Europe and 2.6 in the US. Banks, far from passing on the cut, took the opportunity to widen margins and cover their losses. "By increasing margins, they may be trying to dry up bank toxic assets," noted one analysis.

Inflation, deflation, or the Japanese trap

The debate centered on what would come next. Some antiestéticared runaway inflation—"a loaf of bread will cost 2 euros"—while others saw the specter of Japanese-style deflation. "Welcome to Tokyo 1995," summarized one intervention. The central banks’ decision to expand the deposit guarantee fund to 100,000 euros only increased distrust: if yesterday someone didn't trust the bank, today even less so, because their savings would yield less.

And now what?

The consensus among skeptics was that this solved nothing. The crisis was not about rates, but about liquidity and confidence. "There is no water movement in a dry stream," one analysis concluded. And the risk that all this would end in the covert nationalization of banking or a deflationary spiral was on the table. Meanwhile, markets digested the news and the Euribor remained at 13. Time would tell if it was the beginning of the end or just a breather before the next blow.

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