Friday, October 03, 2008

An answer to a previously asked question

On Tuesday I asked why it mattered that the TED spread was so large. What incentive do banks have to borrow from each other at a high rate when they can borrow from a Central Bank at a lower rate? I found half of my answer at EconBrowser. James Hamilton asks:

"Why would a bank want to borrow overnight dollars for 5-6% in London when it could be assured of obtaining those same funds for 2% later that day in New York?"

He breaks the TED spread down and deduces that a risk/liquidity premium makes up half the difference and the difference between the Federal Funds rate and the 3 month T-bill makes up the other. The Fed cutting the interest rate (as they're expected to do) will push the two rates closer together but:

"What's the downside to that? Here's the next shoe that could drop: the financial dislocations could lead to a perception by global investors that the U.S. is no longer a safe place to be putting their capital, which could add a currency crisis component to the present financial turmoil...if a cut in the fed funds rate leads to rapid dollar depreciation and commodity inflation, it could be pulling the trigger on something even scarier than what we've seen so far."

Not good at all, but this seems to echo the consensus among economists--the worst is yet to come. The TED spread, by the way, rose after the Rescue Package was signed into law.

One thing lacking in the national news is the hemorrhaging in Western Europe, Russia, and Asia, but particularly Russia.

So my next question for any economists surfing by is this:
Why is the Yield Curve for Treasuries still upward sloping? Is it because the interest rate on short-term Treasuries have dropped so low in the flight to safety that longer-term rates must be higher? So, we expect interest rates and inflation to rise in the future?
Because it's not predicting a recession and hasn't this whole time. And the Yield Curve is one of the best predictors of a recession. I would at least expect it to be flatter as I doubt rates will be rising significantly anytime soon. Any thoughts?

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