What’s a central bank to do?

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Global financial institutions are deleveraging because they can’t build enough equity capital any other way except by going to Asian and Middle Eastern sovereign wealth funds, cap in hand. So, the Fed and the Bank of England (BoE) have both cut interest rates. Yet, LIBOR remains stubbornly high. The TED spread is still 85 beeps. Banks just don’t trust each other. What’s a central banker to do?

Honestly, I don’t know. The UK Bubble has a good post on this issue called UK Bubble: A lesson from America. The Fed has cut rates way too low for the second time in 5 years. Instead of a housing bubble, we now have a commodity bubble. The U.S. Dollar has tanked and long-term rates are no lower than they were before this rate cutting exercise began — not a very effective way to get mortgage rates down.

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The UK Bubble makes the same point the boss of HSBC has been making: the inflation genie is out of the bottle. Stop cutting rates or you’ll never get that genie back in. You know you have an inflation problem, when bankers are begging you not to cut rates.

But, my greater worry is deflation. De-leveraging is a deflationary force by its very nature. If the BoE doesn’t figure out a way to stop the Bradford and Bingleys of this world from coming apart at the seams, the things in the UK are definitely going to go pear-shaped. I agree with Alice over at the UK Bubble that easy money is the problem, not the solution. However, one needs to be vigilant about the prospect of another Northern Rock in the UK, the US, or elsewhere.

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Anyway you look at it, Mervyn King has a real problem on his hands. What would you do?

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