The world's central banks are flying blind in a way they have rarely had to before as they try to secure the global financial system amid the current credit scare.
On the morning of Aug. 9, when the European Central Bank's executive board decided to pump cash into a market in which commercial bank loans were suddenly drying up, it took the bold step of telling banks they could have as much money as they wanted at the bank's current 4% base rate -- without limit. The bank had never done that before.
It was a big gamble and a key test for a young institution that, in the past, has been accused of moving too slowly and conservatively. Now, some wonder whether the ECB will make another bold move and back away from its previously signaled decision to increase interest rates at its next meeting on Sept. 6 -- a move now complicated by the Fed's surprise decision Friday to cut the U.S. discount rate by half a percentage point.
The ECB has been at the front of a global liquidity infusion that's seen central banks around the world inject billions into the financial system since the credit crunch emanating from fears about the subprime-loan market hit euro-zone money markets this month. On Friday, the central banks of Russia and Kazakhstan intervened to prop up domestic money markets hit by a liquidity squeeze. Russia's central bank injected 42.4 billion rubles ($1.64 billion) into its money market.
The cash injections are nothing new for the world's monetary policy makers. In the past, the ECB and other central banks have also staged major interventions to help markets when liquidity got tight -- most significantly after the Sept. 11, 2001, terrorist attacks. But never before had the ECB told banks ahead of time the sums available were unlimited. The reason for the change: This time, as former Defense Secretary Donald Rumsfeld once put it, they knew what they didn't know.
In the current crisis, banks have been spooked by the fact they don't know who is guaranteeing bad debt from the U.S. subprime-mortgage market: These days, banks routinely lay off risk through complex and opaque investment instruments. For the ECB, the best way to figure out how much money it would take to ease euro-zone banks' nerves was to let them take what they wanted.
The banks wanted a lot. In the Aug. 9 move, the ECB gave nearly €95 billion ($127.45 billion) to 49 bidders, in a loan that needed to be repaid the next day. In the days that followed, the ECB kept injecting short-term funds. But with a clearer idea of just how much cash the market needed to keep functioning the bank was able to decide when to turn off the spigot, showing it was both willing to help the markets and in control of the situation. By early this past week, overnight rates were back to normal, around 4%.
ECB staff recognize that this is a defining moment for a very young bank. The ECB, which manages monetary policy for the 13 countries that share the euro currency, was founded on June 1, 1998. Its unexpected intervention swept aside longstanding accusations of conservatism. It also heralds the new reality of a globalized financial system that has become so complex that locating risk -- even for central bankers with reams of market information at their fingertips -- has become more art than science.
"It was exemplary central banking," says Erik Nielsen, senior European economist with Goldman Sachs in London. French President Nicolas Sarkozy, who has long challenged the ECB to focus on jobs and growth rather than just inflation, also commended the bank's actions in a letter on Thursday urging G-7 leaders to focus on finding ways to locate where risk lies in the financial system.
To be sure, not everyone thinks the ECB's dramatic move was such a good idea. Immediately after it announced it would make unlimited funds available to the markets, many investors panicked, assuming the ECB had inside knowledge of a pending crisis.
Other critics note the bank's decision to offer unlimited funds at a cost no higher than the going rate risked creating a so-called moral hazard, encouraging banks to keep taking the kinds of risks that helped to start the subprime crisis to begin with.
"Central banks are responsible for financial stability today as well as tomorrow," said Paul de Grauwe, economics professor at the Catholic University of Leuven, in Belgium. He said the ECB "maintained stability today, but created instability for the future." He thinks the ECB should have made banks pay a higher interest rate for the funds it injected.
♠ Posted by Emmanuel in Europe at 8/18/2007 06:15:00 PMThe ECB's President Jean-Claude Trichet faces a quandary when he chairs that body's next meeting on September 6. Previously, the ECB had telegraphed to the markets that it would raise the Eurozone's target rate from 4.00% to a likely 4.25%. With all the commotion going on in global markets over the spreading US subprime issue, though, a raise may no longer be such a sure thing. Another consideration is that European economies aren't exactly "decoupling" from the US slowdown as many had predicted earlier. EU economies are noticeably slowing down and may slow even further with an untimely rate rise. Be reminded that the question raised here, however, is not whether Trichet will pull another Bernanke put (rate cut) but whether the ECB will raise rates. From the Wall Street Journal: