Tuesday, December 18, 2007

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

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 ...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.

9am EST Update: Today's monster monetary injection by the ECB ended up being even larger than expected, amounting to 348.6 billion euros (or about $501 billion). The two-week Euribor fell a record 50bps to 4.45%. But in spite of this massive intervention it is still 45bps above the 4% policy rate of the ECB; so even with this unprecedented intervention the ability of the ECB to unclog the money markets has been only partially successful. Thus, while a massive injection of liquidity of $500 billion partially reduced the crunch at a short term maturity of two weeks - the one that covers the year end "turn" it has done little to nothing to deal with the liquidity crunch at a 3 month horizon.