CENTRAL banks will have to cut interest rates aggressively to contain the market crisis, leading economists say. They predict that Friday’s surprise move by the Federal Reserve to reduce its discount rate will need to be followed by a series of reductions in its main Federal funds rate.

The prospect of rate cuts by the Fed make rate hikes in Britain and Europe look increasingly unlikely, analysts say. Some are pencilling in interest-rate cuts in Britain for next year.

Bernard Connolly at Banque AIG said the Fed would need to cut rates to 2001-2 levels, when they were reduced to 3%.

“I said as long ago as 2001 that this cycle would reassert itself and the Fed would again need to provide the incentive for people to spend,” he said. “I have sympathy with the view that a lot of silly things have been done in financial markets. But in the end, the main role of a central bank is financial stability, and in this you have to accept a degree of moral hazard.”

BACKGROUND

• Elephant slumps in wake of crunch

• Heads on the block, investors call for change

• Credit crunch forces Delek to leave property deal

• US rate cut looks certain after new data

• Bank of America to axe 3,000 after 'our errors'

BACKGROUND

• More pain for private equity industry

• Russian state bank poised to boost liquidity

• House prices‘to stay flat for years’

• Will soaring oil pump up inflation?

• US bank slump goes on

Black clouds loom on horizon

For the first time in 15 years, I am seriously worried about the outlook for the economy, the housing market and sterling

Float on the job market

Don't believe the scary headlines. It's not the worst time to consider a career in banking

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• Markets rebound as US Fed acts to ease squeeze

Economists now predict two rate cuts by the Fed before the end of the year. “Our new base-line forecast is a replay of 1998 where the Fed cuts to unfreeze the markets,” said Ethan Harris, chief economist at Lehman Brothers in New York. “We would expect cuts at both the September and October meetings.”

Robert Barrie at CSFB in London said the credit crisis was likely to hit bank lending in Britain, slowing both consumer spending and investment.

“The market has taken out the rate rises it priced as recently as last week,” he said. “It may be time to attach some probability – albeit a low one at this point – to an ease, and possibly a material one, sometime next year.”

George Magnus at UBS predicts equities will fall sharply, despite Friday’s strong recovery.

“I expect the market to go down again,” he said. “It may sta-bilise for a week or two and investors may hold their fire. To be honest, it is almost fair to say that the Fed is powerless to arrest the trend of the deleveraging of the markets.

“This will spawn a long tail of problems and casualties. The fall could be 20% or 30% – it’s hard to know – but there will be further dives in share prices.”

A series of US mortgage lenders have already collapsed, but there are fears that other big finance firms could also run into serious difficulties. “The idea that a sizeable financial institution could have to be recapitalised is not beyond the realms of possibility,” said one strategist at an investment bank.

“When part of the commercial-paper market is shut down to normally functioning banks, that shows there is a real problem going on,” said Magnus.

Some economists argue the malaise in the markets could infect the wider economy. Albert Edwards at Dresdner Kleinwort estimates there is a 40% chance the US economy could tip into a recession. “The market should have been nervous of the threat. Until Thursday, people were claiming the problems were just a repricing of risk in the credit markets. Recession is now a much greater possibility.”

Connolly, who came to prominence when he blew the whistle, as a former European commission economist, on what he described as the rotten heart of Europe, predicted tough times ahead for some EU countries, which ran the risk of a “1930s-style depression”.

Unless the European Central Bank was prepared to tolerate higher inflation, he said, the result could be catastrophic for southern European countries and Ireland, which were already suffering from higher interest rates. “Ireland could be the canary in the mine,” he said.

Tension in the markets was reinforced by Hurricane Dean in the Gulf of Mexico. Traders fear a repeat of Katrina two years ago, which seriously disrupted oil supplies and pushed prices sharply higher. Crude oil prices, which had been weakening as a result of concern over the global economy, bounced back to just under $72 a barrel.

The credit crunch could cost JP Morgan Chase about $1.4 billion (£700m) of second-half profit because of loans it cannot sell, according to an analyst at Citigroup. The Wall Street bank has been the biggest lender in the leveraged buyout market but will not be the only one to suffer, said the report.

Goldman Sachs Group, Deut-sche Bank and other underwriters of loans to finance leverage buyouts face similar shortfalls, according to Citigroup analyst Keith Horowitz.

Horowitz calculates JP Morgan is stuck with $40.8 billion of LBO debt, while Goldman is holding $31.9 billion and Deut-sche $27.3 billion. JP Morgan declined to comment Horowitz’s report was published on July 26. He said the market was suffering from a “buyer” strike. The situation is likely to have worsened since the report was put out. “Market estimates indicate a $300 billion pipeline of deals in the US – $200 billion of loans and $100 billion of high yield,” Horowitz wrote.

“The banks have committed to underwrite these loans and bridge loans, so one of the issues is if the banks are unable to sell the paper, they will be forced to put the debt on the balance sheet.”

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