US Sub Prime lending crisis causes cut in Interest Rates
By Phillip McGann, 20/09/07

Overnight the Federal Reserve (the US Central Bank) cut interest rates by 50 basis points or one half of one percent in response to the credit crunch that is gripping US and world credit markets.

The sub- prime crisis that has unfolded over recent months has led to a severe “seizing up” of credit markets around the globe. The fear in the market has spread from the borrower level to the banks themselves.

The fear has spread to the inter-bank loan market itself where banks are wary of lending to each other for fear of counter party risk. Each bank is worried about whom among them will be the next to announce a massive exposure to the sub prime melt down.

This has led to large increases in “margin spreads” (or the amount of interest above a set benchmark that each borrower must pay to access funding), as risk has been priced higher and higher. In numerous cases, lending has not been forthcoming at all at any price.

This has led to a (legitimate) fear that the real economy for good and services will be next to feel the blow torch of the sub prime crisis in the form of higher costs and inflation. This would then lead to lower economic output, rises in un-employment and ultimately recession.

Into this mix the Fed strode last night with its rate cut in an attempt to free up the credit markets by pumping cash into the markets in the form of lower interest rates.

Will it be enough to settle the markets? OR is it just rewarding bad behaviour and will this in itself stoke inflation? 

The equity markets thought it was a positive move with US shares jumping 3.5% but we will have to wait a few days, weeks or months to see the real long-term impact.