CROESUS: An investor's viewOn Tuesday the US Federal Reserve duly reduced the fed funds rate by a quarter point to 4.25 per cent. Judging by the ensuing sharp falls in global equity markets, it would seem that many traders had expected a larger half-point cut. However, the Fed is walking a tightrope between avoiding a recession on the one hand and controlling inflation on the other hand.

The reduction in the official interest rate acknowledges the fact that the US economy is slowing and the housing slump is getting worse. The Fed's statement after its decision did recognise the intensification of the housing correction, but it also stated that, although "readings on core inflation have improved modestly this year, elevated energy and commodity prices may put upward pressure on inflation".

Despite this concern regarding inflation, the tenor of the Fed's statement suggests that the central bank is more worried about the risks to growth. Therefore, another quarter-point cut in fed funds is likely to occur in January, with further reductions likely during the first half of 2008. The Fed also reduced the discount rate, which is the rate at which it lends directly to the banking system, by a quarter point. Many in the market had expected a larger reduction in this rate given the ongoing tightness in the money and credit markets. It may well be that the small reduction in this rate caused the initial market sell-off. It is abundantly clear that conditions in the money markets have been worsening over the past month. The evidence for this lies in the widening gap between official rates and interbank or wholesale money rates.

Normally, three-month interbank rate trades at about 20 basis points above official rates. Since the summer the gap has been consistently higher.

In the aftermath of the first Fed easing, conditions improved in September and October. However, large write-offs from banks such as Citibank and UBS, among others, have increased nervousness regarding the credit-worthiness of all banks. Furthermore, many financial institutions would seem to be hoarding liquidity as we approach year-end.

As the table shows, this has led to sharp rises in three-month interbank rates in the US, UK and Europe. The gap is most pronounced in the UK at 113 basis points (bps), but the euro and dollar are not far behind at 93bps and 86bps respectively. The persistence and magnitude of these gaps are indicative of ongoing severe stress across the global banking system.

Therefore, reductions in official interest rates in the US and the UK have been negated by rises in market rates. With its latest cut the Fed has now reduced its fed funds rate by a full percentage point. Yet the one-month dollar Libor (London interbank offered rate) is at 5.2 per cent and the three-month dollar Libor is at 5.1 per cent.

This means that despite the lowering of rates by the central bank, monetary conditions in the US have barely eased. In Europe monetary conditions have tightened quite dramatically even though the European Central Bank has kept the repo rate at 4 per cent.

The money market yield curve indicates that market rates are likely to remain well above official rates for at least the first half of 2008.

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Over the past week many airlines have been reporting November traffic performance. EasyJet reported passenger  growth of 13 per cent to 2.9 million and a load factor increase of 0.3 per cent to 80.8 per cent.

Air Berlin reported passenger growth of 19 per cent to more than two million with an increase in its load factor to 72.1 per cent. Meanwhile, Aer Lingus reported an 8 per cent growth in passenger numbers to 727,000 but load factors were lower than expected. The short-haul load factor was down 2 per cent to 68 per cent reflecting competitive pressures.

The long-haul load factor was down 6.7 per cent to 79.3 per cent in November despite strong traffic growth of 18.9 per cent due to increased capacity on long-haul routes. On a year-to-date basis, total passenger numbers have grown by 7.7 per cent to 8.6 million and the load factor is down 1.9 per cent to 76.1 per cent. Although these figures were a little disappointing, Aer Lingus is forecast to generate profits of about €100 million in 2008. The company has a strong balance sheet with net cash of ¤800 million that will enable it to comfortably fund aircraft purchases.

There is also substantial hidden value in its balance sheet as open skies between Europe and the US has enhanced the value of its Heathrow slots.

It is difficult to put a monetary value on these slots, but they clearly have substantial strategic value.

At the current share price of just over €2, Aer Lingus offers interesting long-term value.