All eyes on Fed

The US Federal Reserve will cut interest rates at its meeting on Tuesday -- that is a foregone conclusion.  But by how much?

There is furious speculation on Wall Street over whether the cut will be 25 or 50 basis points. It remains to be seen whether a rate cut will have any effect on the recent credit crunch, particularly in asset-backed commercial paper, other than giving markets a morale boost. 

The problem in credit markets is that a collapse in demand for short-dated bonds has led to a contraction in liquidity in the interbank markets.  Banks are simply not willing to lend to each other. Central banks, most notably the ECB, have injected large amounts of liquidity into money markets in order to get credit flowing again, but interbank lending rates have nevertheless remained stubbornly high.  What is more, the cost of borrowing for longer maturities remains largely unchanged.  This indicates that the problem is one of trust.  Banks are worried about what lies under their counterparts' bonnets.  This may simply reflect the fact that the expansion of structured finance, which distances borrowers from originators of loans, has made it increasingly difficult to determine where risk lies. But it could also mean that somewhere, one or several banks are running on empty.