More gloomy talk overnight from the US Federal Reserve and the International Monetary Fund, which sees total losses from the credit crunch ballooning past $A1 trillion, with most of that still to come.

The IMF warning was contained in its latest Global Financial Stability Report, which is a precursor to the release of its World Economic Outlook tonight. It said: “The current turmoil is more than simply a liquidity event, reflecting deep-seated balance-sheet fragilities and weak capital bases, which means its effects are likely to be broader, deeper and more protracted”. The IMF also warned of the risk of “a serious funding and confidence crisis that threatens to continue for a significant period.”

It was enough to make the most resilient of bankers stand and gaze longingly at the ledge outside the window in their Wall Street, City of London or Collins Street office block. But as harsh as the commentary and forecasts were, a bit of corrective reality is needed.

Both the Fed and the IMF spent 2007 underplaying the dangers of the subprime implosion and the slump in US housing. For months it was seen as only impacting the US housing sector and with limited damage in finance. We now know it had crunched credit and other financial markets worldwide in the worst crisis of confidence in at least 50 years.

In economists’ terms, the Fed and the IMF both “undershot” in their forecasts last year, so the question has to be asked, are they now overshooting with a view that’s too gloomy and unnecessarily bearish?

The Financial Times said in an editorial today:

The International Monetary Fund has had a strange credit crunch. Like a mighty navy rendered impotent because all of the fighting is inland, the IMF has been impotent: all of the liquidity and solvency problems have hit individual banks, rather than the countries it is set up to rescue. That makes its policy and monitoring efforts, such as yesterday’s Global Financial Stability Report, all the more important.

It is the extent of the economic slowdown caused by the credit turmoil that will determine whether there is more financial pain to come. Most people will keep paying their mortgage in the face of falling house prices, but a deep recession would produce high unemployment and people without jobs cannot pay their debts. There is also the risk that financial losses will cause investors to lose confidence in specific economies and currencies.

The squeeze is not yet over. The IMF may yet be called upon to rescue somewhere before it is.

And that’s why the views of the Fed are probably more accurate, if only because the US financial markets went to the edge when Bear Stearns was bailed out last month. 

So the remarks in the minutes for the Fed’s 18 March board meeting aren’t from a group of pen pushers distant from the day to day pain of the credit crunch: they had to face up to the worst fears of any central bankers — systemic damage from the domino effect of a major bank failing.

The minutes said: “The staff projection showed a contraction of real GDP in the first half of 2008 followed by a slow rise in the second half.”

But they also said some policymakers believed that “a prolonged and severe economic downturn could not be ruled out given the further restriction of credit availability and ongoing weakness in the housing market.”

Several participants at the meeting noted that it had become “increasingly difficult” to value complex mortgage-related securities amid the ongoing credit crunch and that the “ongoing strains were likely to raise the price and reduce the availability of credit to businesses and households”.

Of the two forecasts I’d pay closer attention to the Fed. China remains the key: if it see a sharp contraction in growth and activity, then nothing will stop a global slowdown.

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Peter Fray
Peter Fray
Editor-in-chief of Crikey
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