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The credit crisis: why it is still too early to relax

First published: Financial Times, 09/10/2007

Milton Friedman, writing about the role of monetary policy, once wrote: “From the infinite world of negation, I have selected two limitations of monetary policy to discuss.”For this champion of monetarism, the limitations at the time (1968) were the inability of monetary policy to peg interest rates and unemployment for more than limited periods. As we face a turn in the credit cycle, the effectiveness of monetary policy is again under scrutiny. The shift in monetary policy in the US and Europe is a key reason for buoyant equity markets even as credit markets remain dysfunctional. Applying Friedman’s language to financial markets, I have three propositions to negate – or at least to question.The first is that the credit crisis is over. Tensions in credit markets have certainly eased but there remains much that is not yet normal. Deal flow has picked up. Investment grade bond and credit default swap spreads have fallen back from their recent highs, as have US dollar and sterling interbank rates. Banks have been admitting their losses from the credit seizure. Even so, it is unlikely that markets will return to anything like the status quo ante. Confidence between lenders and borrowers remains low. The scramble for liquidity is still ongoing, as evidenced by euro interbank rates, which are still hitting new highs. In a nutshell, reducing debt levels and addressing balance sheet issues have only recentl…more