Hugo M asked: Plugging holes
Central banks’ latest moves to increase liquidity will ease but not solve the credit crunch
YOU might call it the sandbag approach to central banking. As the turmoil in credit markets deepens and broadens, central banks, particularly America’s Fed, have devised ever more ways to bolster the markets against collapse by providing more funds to more actors, for longer periods and against broader ranges of collateral.
This week brought the latest round of sandbagging. In two announcements, on March 7th and 11th, the Fed promised a series of new measures. It expanded the facility through which banks can bid for liquidity and introduced a new scheme under which the central bank would provide up to $200 billion of Treasury bonds to market-makers in return for dodgier assets, such as mortgage-backed securities. On March 11th, other central banks joined in too.
Financial markets were delighted. Wall Street’s main share indices enjoyed the biggest one-day rise in over five years. But the optimism did not last. Within days dollar selling drove gold above $1,000 an ounce and the dollar below ¥100. Though the Fed’s tools are useful, the bad news is not over.
The logic behind broader liquidity provision is simple: to break a vicious circle of fear and forced selling. In recent days, many corners of the credit markets were becoming dysfunctional, with investors refusing to hold all but the safest government bonds. Spreads in normally safe and liquid markets, such as bonds issued by the quasi-official mortgage giants, Fannie Mae and Freddie Mac, widened alarmingly and prices wobbled. Higher volatility and wider spreads prompt banks to demand more collateral from borrowers, which in turn exacerbates the mess. By offering the safe Treasury bonds that investors crave, and holding unwanted securities in return, the Fed intends to block this spiral. A modest risk
That makes a lot of sense. By reducing the panic-induced part of widening credit-spreads, the new liquidity tools mitigate the damage that dysfunctional credit markets would otherwise wreak on the economy. They also take the pressure off the central bank’s other, rather blunter, policy tool—lower interest rates. The Fed has already slashed short-term interest rates by 1.25 percentage points in the past two months, in part to counter the credit turmoil. Before this week’s liquidity actions, financial markets expected another three-quarter-point cut at the Fed’s next rate-setting meeting on March 18th. With commodity prices soaring, the dollar plumbing new depths and expectations of future inflation on the rise, such a large rate-cut would be risky. The new liquidity tools reduce the odds that the Fed is spooked into recklessness.
Equally important, these gains come at only modest risk. The Fed will hold dodgier securities. But by taking them as collateral for temporary loans and at a discount, it would lose money only if there is a bankruptcy among the market-makers borrowing Treasury bonds. The ECB has long taken such securities as collateral. In the long term, central banks’ willingness to broaden liquidity support during crises may induce banks to behave more riskily (a temptation that will need to be countered with more effective rules on banks’ own liquidity). But that hardly seems a problem today. The biggest danger is excessive expectations. Liquidity provision, however artful, is not a magic bullet for the credit crunch. It alleviates panic and buys time, but does not eliminate the underlying losses, get rid of the uncertainty about who holds them, or prevent the inevitable credit tightening that will follow. And the bad news is far from finished. As foreclosures and falls in house prices accelerate, estimates of likely losses on mortgage-backed securities, now around $400 billion, are still rising. The credit contraction these losses will spawn has hardly started. Yet the economy is already in recession. That is not official, but the latest jobs figures, which showed private-sector employment falling in each of the past three months, leave little doubt that the economy is contracting. More mortgage losses will result as joblessness spawns foreclosures, along with higher defaults on everything from credit cards to corporate loans. There are some bright spots. Banks are limiting the scale of the squeeze by raising new capital, over $100 billion so far—though they could raise more. The downturn is being cushioned by still-strong global growth. George Bush’s fiscal stimulus package will soon add a short boost. But, all told, recession suggests the credit problems will get worse before they get better. The Fed’s sandbag strategy will help ward off disaster, but it won’t shore up a sagging economy.
Russell
