Wednesday, December 19, 2007


Central Banks Are Getting Desperate in Dealing with the Liquidity Crunch and Resorting Again to Stealth Reductions in Policy Rates

Central banks are obviously getting frustrated and effectively desperate in dealing with a most severe liquidity crunch that has gotten significantly worse since August. Even last week’s coordinated announcement of central banks monetary injections has done little so far in reducing the Libor spreads (at maturities from two weeks to 3 months) relative to overnite policy rates, relative to government bonds of matching maturity and relative to the Overnite Index Swap (OIS) rate. The three month Libor versus policy rate differential is still 69bps in the US, 95bps in the Eurozone (its highest level in years); and 93bps in the UK. We will see the effect of the first of the TAF auctions by the Fed on Wednesday but there is little reason to believe – based on current spreads – that this first auction has eased liquidity conditions in interbank markets. As pointed out by Cecchetti the kind of new auctions at term horizons that the Fed is performing now have been performed by the ECB for a long time; and in the Eurozone such auctions has so far miserably failed to reduce the various Libor spreads; so why would these new instruments be effective in the US if they have not been effective in the Eurozone?
So central banks are now becoming even more creative in dealing with the liquidity crunch and starting to do the kind of stealth policy rate reductions that they performed last August and September.
The ECB just announced a special liquidity operation that will allow financial institutions to borrow for two weeks unlimited amounts at a rate of 4.21% (close to its policy rate of 4%); the two-week euro Libor had been 4.9% before the announcement. So the ECB is providing a temporary monetary policy easing of 70bps for a two week period.
The operation is highly unusual and heterodox; and while getting creative in dealing with liquidity crunches may be appropriate this action signals some desperation on the part of the ECB. The problem is that the ECB is the only G7 central bank – apart from the BoJ – that has not reduced at all its policy rate. And since most financial and other private contracts are indexed to Libor, an average Libor that is about 100bps above policy rates it is equivalent to the ECB having raised its policy rate by 100bps in the last few months. So not only the ECB has not reduced its policy rate in spite of major signals and risks of economic slowdown in the Eurozone (oil price shock, strong euro hurting European competitiveness, effects of the US sharp slowdown, liquidity and credit crunch, sign of a slowdown in economic activity, beginning of a deflation of housing bubbles in Europe); it has effectively increased its policy rate by 100bps as Libor – rather than the policy rate – is the relevant cost of capital for the financial system.

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