From the Economist: Central Banks / Unclogging the system

[Guy Berger]

Central Banks

Unclogging the system

Dec 13th 2007 | WASHINGTON, DC

From The Economist print edition

Working together, central bankers try showering cash on the credit crisis

Shutterstock

CENTRAL bankers are supposed to be boring and predictable. But on Wednesday December 12th the rich world’s monetary authorities stunned financial markets with a dramatic, joint plan to ease the liquidity squeeze in global money markets. America’s Federal Reserve, the Bank of England, the European Central Bank (ECB), the Bank of Canada and the Swiss National Bank all pitched in. The central banks of Sweden and Japan said they, too, were watching developments and would act as necessary. All told, it was an impressive show of central-bank co-ordination.

Financial markets have been seizing up for weeks. The spreads between the federal funds rate and the prices charged by banks to borrow from each other have widened dramatically since early November. By some measures, the financial system is more blocked than it was in September. And it has long been clear that central banks’ attempts to sort out the mess are failing. The Fed’s discount window, for instance, through which it lends direct to banks, has barely been approached, despite the soaring spreads in the interbank market. The quarter-point cuts in its federal funds rate and discount rate on December 11th were followed by a steep sell-off in the stockmarket, only partly reversed the next day.

The central banks have pinched each others’ best ideas for how best to ensure that liquidity gets where it is needed. And they have also, in effect, acknowledged the international nature of the liquidity squeeze, by promising to provide reciprocal currency-swap lines.

The Fed made the most dramatic changes. It introduced a “term-auction facility” through which all banks eligible to borrow from the discount window could bid for one-month money. The first two auctions are to be held on December 17th and 20th, with $20 billion to be sold at each. Two more are to follow in January. The Fed also announced temporary swap lines with the ECB and the Swiss National Bank, worth $24 billion, allowing those central banks to lend dollars to banks pledging euros or other currencies.

The Bank of England promised to inject more money into the markets, increasing its two forthcoming term auctions, on December 18th and January 15th, from £2.85 billion ($5.8 billion) to £11.35 billion each time. In all, £20 billion will be supplied at three-month maturities, where strains have once again become particularly acute. And unlike its previous emergency auctions, in late September and October, the price of these funds will be determined by market demand at the auction, not set at the penalty rate that deterred any bank from bidding for the money.

The hope is that by extending the maturity of central-bank money, broadening the range of collateral against which banks can borrow and shifting from direct lending to an auction, the central bankers will bring down spreads in the one- and three-month money markets. There will be no net addition of liquidity. What the central bankers add at longer-term maturities, they will take out in the overnight market.

In some ways, the announcement is a triumph for the ECB. Both the Fed and the Bank of England have shifted away from the familiar tools of a lender of last resort—providing funds freely to institutions at a penalty rate. They have moved closer to the ECB’s approach of auctioning funds to a broader set of actors against a wider range of collateral—in effect becoming a market of last resort. The shift makes sense: in both Britain and America it was increasingly clear that the stigma associated with approaching the central bank directly was deterring deserving borrowers. Walter Bagehot’s dictum needed updating when the crisis of confidence affected entire markets rather than single banks.

But there are risks. The first is that, for all the fanfare, the central banks’ plan will make little difference. After all, it does nothing to remove the fundamental reason why investors are worried about lending to banks. This is the uncertainty about potential losses from subprime mortgages and the products based on them, and—given that uncertainty—the banks’ own desire to hoard capital against the chance that they will have to strengthen their balance sheets. Nor is the shift from direct lending to auction sure to work: for all the praise heaped upon the ECB, the spread between the ECB’s repo rate and euro-denominated interbank rates is no less worrying than that in America or Britain.

Furthermore, central banks will now be more intricately involved in the unwinding of the credit mess. Since eligible banks have similar access to the liquidity auction, the central banks are implicitly subsidising weaker banks relative to stronger ones. By broadening the range of acceptable collateral, the central banks are taking more risks onto their balance sheets.

Set against the dangers of all-out financial seizure, these risks seem worth taking. More important, if they succeed even in modestly loosening the money markets, they will reduce the pressure on central banks to use the broader tool of lower interest rates. Across the developed world monetary policy is becoming increasingly hard to steer. Growth is slowing, because of the fall-out from the financial turmoil and the weakening American economy. In its recent Economic Outlook the OECD revised down expectations for 2008 growth in virtually every country. Yet strong demand growth in emerging economies is stoking commodity-price inflation. In America consumer-price figures due on December 14th may well show that, thanks to soaring fuel costs, overall consumer prices rose 4% in the year to November. Even if financial markets were functioning normally, central bankers would face hard choices. With the system gummed up, that calculus is harder still.

[The Magnificent Goldberg]

Thanks for posting that Guy. It's the jargon in articles like this that brings it home to me that I'm not a REAL economist It looks worrying, though, particularly the thought that this action is subsidising duff banks as well a sound ones. If it all goes pear-shaped, most of the western world's currencies will be in for a devaluation - perhaps a big one, depending on how like a pear it is.

This is what we got this morning - somewhat less jargon. Is it still correct, Guy?

Reuters - Thursday, December 13 08:04 amLONDON (Reuters) - Chancellor Alistair Darling welcomed the coordinated move by central banks to combat the credit crunch, telling a newspaper on Thursday that the action was needed to send a clear signal to the world.

"This was both necessary and very welcome," he told the Guardian.

"It sends a very clear signal across the world that central banks stand ready to do whatever is necessary."

Darling said he had been in constant contact with the governor of the Bank of England, Mervyn King, in recent weeks in an effort to tackle the impact of frozen credit markets that have affected British bank Northern Rock and other lenders.

Darling's comments followed a move on Wednesday by central banks around the world to take coordinated action to boost liquidity, their first joint action since the September 11, 2001 attacks on the United States which paralysed U.S. markets.

The U.S. Federal Reserve, the European Central Bank and the central banks of Canada, England and Switzerland announced steps to make it easier for stressed banks to access cash in the hopes of quelling the knock-on impact of the credit crunch.

The Bank of Japan and Sweden's Riksbank also issued statement saying they were lending support to the plan.

The credit crunch, sparked by the sub-prime lending crisis in the United States, has led to conditions in which banks are reluctant to lend to one another, driving up the cost of overnight borrowing and tightening most financial market operations.

It is expected to have a deep impact on economic activity in the United States and elsewhere, with the U.S. economy forecast to slip into recession as a result, slowing growth worldwide.

(Reporting by Luke Baker)

Here's the link. Nice pic of Darling, who is a very tough cookie, compared to Mervyn, who's a sweetie.

http://uk.news.yahoo.com/rtrs/20071213/tuk...-fa6b408_1.html

MG

[Guy Berger]

The UK's most boring politician, IIRC. I was surprised to discover (at the beginning of the NR crisis) that he was Brown's Chancellor, I had always assumed he was a Blairite. Wasn't he involved in the sexing up of the Iraq dossier?

Guy

[The Magnificent Goldberg]

The UK's most boring politician, IIRC. I was surprised to discover (at the beginning of the NR crisis) that he was Brown's Chancellor, I had always assumed he was a Blairite. Wasn't he involved in the sexing up of the Iraq dossier?

Guy

Never heard that about him. But if he was, that would kind of make him not boring, wouldn't it? He was a very tough Chief Secretary to the Treasury (the job is to cut spending plans down to size) in the early days of the Labour Government.

MG

[Guy Berger]

The UK's most boring politician, IIRC. I was surprised to discover (at the beginning of the NR crisis) that he was Brown's Chancellor, I had always assumed he was a Blairite. Wasn't he involved in the sexing up of the Iraq dossier?

Guy

Never heard that about him. But if he was, that would kind of make him not boring, wouldn't it? He was a very tough Chief Secretary to the Treasury (the job is to cut spending plans down to size) in the early days of the Labour Government.

MG

I actually got him mixed up with Alastair Campbell.

When the Northern Rock debacle started I read AD's wikipedia biography, he apparently won the "most boring politician" in several polls. Also "Darling's Darlings" and the cat named after Sybil Fawlty.

Guy

[sidewinder]

I actually got him mixed up with Alastair Campbell.

He wasn't even an elected politician but Blair's press secretary, believe it or not.

Now 'retired', having written a book and doing the innevitable dinner speech circuit.

[Guy Berger]

Thanks for posting that Guy. It's the jargon in articles like this that brings it home to me that I'm not a REAL economist It looks worrying, though, particularly the thought that this action is subsidising duff banks as well a sound ones. If it all goes pear-shaped, most of the western world's currencies will be in for a devaluation - perhaps a big one, depending on how like a pear it is.

This is what we got this morning - somewhat less jargon. Is it still correct, Guy?

MG,

The basic punchline is that central banks are worried that the current credit crunch is (A) going to generate widespread chaos in the financial system and (B) going to generate spillovers into the rest of the economy in the form of tighter lending. (In other words, the crunch is causing a large effective tightening of monetary policy even though policy rates have not gone up.) The belief is that traditional monetary policy tools (raising and lowering interest rates) are not as effective as they were in the past and that more targeted policy is needed. We will see.

The coordinated announcement itself is sort of a "sunspot", the actions are operationally independent except for the currency swap.

Guy

[The Magnificent Goldberg]

The coordinated announcement itself is sort of a "sunspot", the actions are operationally independent except for the currency swap.

More, it seems to me in this case, that apparent action will serve to maintain confidence when scope for real action is lacking. But it doesn't (often) work. Although it's true that there's one born every minute, the corollary is also true.

MG