Are Central Bankers Providing Needed Liquidity or Capitulating? (ECB Intervention Edition)

On Monday, the European Central Bank announced an even more aggressive version of a liquidity facility it had used last August in its efforts to lower interbank lending rates that are stubbornly higher than policy rates. This move is an admission that the coordinated efforts of five central banks last week, including the Fed and the ECB, to stimulate more lending haven’t succeeded.

In August, the ECB had offered banks “unlimited liquidity” on an overnight basis to soothe the markets. This new program is a variant, for a two week term rather than overnight, again offering loans with no ceiling as to total amount, so long as the interest is 4.21% (below comparable Libor). This effort is to reverse a tightening of conditions due to a vastly-worse-than-usual end of year evaporation of funding (banks typically get chary of lending late in the year because their priority is to settle their own books). The impact was swift, at least on two week rates, which dropped from 4.94% to 4.5%. However, there has yet to be much improvement in three month Libor.

Bloomberg, the Wall Street Journal, and the Financial Times all report on this initiative. From the Journal:

Yesterday’s announcement about loans the ECB will supply for a two-week period covering the turn of the year marks the second time in the central bank’s nine-year history that it has said in advance it would meet all bids at a particular rate…..

“It’s an extraordinary move to guarantee all the bids,” said Michael Schubert, economist with Commerzbank in Frankfurt. “But we have a very abnormal situation over year end, and so the ECB decided to do something very unusual,” he said….

Despite the concerted show of force by the central banks, euro-zone banks remain wary of lending to one another for longer periods of time. Three-month interbank rates have edged lower but, at around 5%, they remain higher than usual, given the ECB’s target rate of 4% for overnight loans…..

Rates on two-week funds rose to 4.946% Friday from 4.146% the day before. After the ECB’s announcement yesterday, two-week rates fell back to around 4.5%, a sign that markets were relieved, though not fully reassured.

Because banks now know they can get two-week funds at 4.21%, money-market rates should have fallen close to that level. But fixed-rate tenders favor larger banks with larger stocks of collateral, and that could account for the market’s muted reaction, analysts said.

Overnight rates have fallen to near the ECB’s 4% target. Banks, in fact, are so flush with overnight cash that earlier yesterday, continuing a balancing act of withdrawing very short-term funds while adding extra longer-term cash, the ECB drained €36.61 billion from the system.

Note that one reason that banks may be holding on to cash is that SIVs will be facing new liquidity demands starting in January as their medium-term notes mature.

And from the Financial Times:

“This is basically Father Christmas to those who have access,” said Erik Nielsen, economist at Goldman Sachs. “They are bailing out people who have not really adjusted their balance sheets to the new reality.” But Julian Callow, economist at Barclays Capital in London, said the ECB was “simply doing their job at being lender of last resort”…..

The latest move underlines the limited impact of last week’s co-ordinated central bank intervention and highlights continued operational differences between the ECB and the more incremental Fed and Bank of England.

Update 8:30 AM: Bloomberg reports that the ECB lent over $500 billion today under its new program: Note that even this massive operation lowered rates from 4.94% to 4.45%, still above the 4.21% the ECB had on offer, indicating that even this scale of intervention wasn’t fully effective. Nevertheless, it at least real progress:

The European Central Bank loaned 348.6 billion euros ($501.5 billion) for two weeks to banks to bring down the cost of money at year-end.

The reluctance to lend money after the collapse of the U.S. subprime market pushed interbank euro rates for two weeks to the highest level at least six years earlier this week. The rate banks charge each other for two-week euros fell to 4.45 percent from 4.94 percent, the European Banking Federation said today.

“It won’t fix the actual problem of banks not lending,” said Michael Schubert, an economist at Commerzbank AG in Frankfurt. “It also raises the moral hazard question for the ECB, whereby banks could start relying on getting cheap cash.”…..

The ECB said 390 banks bid for the two-week loans at a marginal rate of 4.21 percent. Bids ranged from 4 percent to 4.45 percent.

In an interesting bit of synchronicity, Kenneth Rogoff, Harvard economics professor and former chief economist for the IMF, picks up on the Santa metaphor in “The Fed must not play Santa to the markets,” arguing in the Financial Times that Fed has been cowed by the demands of self-interested market participants.

Rogoff focuses on the issue of time horizons. Monetary actions have long lag times and are thus central banks are prone to overshoot. Central bankers look out over a longer forecast range than many of the players they regulate (a worrying condition in and of itself):

US Federal Reserve officials were jolted last week by the cacophony of booing that greeted their quarter- percentage-point interest rate cut. Markets badly wanted double the amount. It is part of a growing town/gown rift between a model-oriented Fed and a profit-oriented financial community.

Market commentators, including some former Federal Open Market Committee members, almost unanimously expressed deep disappointment that the Fed did not seem more attuned to the growing risk of recession. The critics were especially peeved that the Fed’s statement did not contain a clear acknowledgement that short-term growth risks easily trump short-term risks to core inflation.

The negative rhetoric cooled a bit later in the week as the big central banks announced new measures to maintain market liquidity, and as high November inflation readings made the Fed’s balance of risk assessment seem somewhat more plausible.

Nevertheless, markets remain ex tremely sceptical. As housing prices sink and the credit crunch grinds on, top private forecasters have been scurrying to downgrade their 2008 growth estimates.

Many now buy into the prediction by Alan Greenspan, former chairman of the Federal Reserve, that the odds of a US recession are at least even money. Is today’s Fed living on a different planet, they ask? One popular complaint is that the Fed’s academic modellers pay far too much attention to slow-moving macroeconomic variables and fail to keep pace with the fast-shifting information embodied in financial markets.

Markets are right to be concerned about recession risks, but there is an awful lot of whining mixed in here. After all, most traders’ year-end bonuses stand to benefit a lot from an even softer Fed policy stance. The markets were not satisfied with one dessert; they wanted two.

It is true the Fed has been repeatedly wrong-footed by the subprime crisis. It badly underestimated both the size of the losses and the virulence of the ensuing global contagion.

Of course, few market analysts have been much further ahead on the curve, which is why so many private forecasters have been tripping over each other in recent weeks to knock down their overly optimistic projections for 2008 US growth.

The real town/gown problem is one of horizon rather than perspective. Monetary policy has long and variable lags, particularly on slow-moving inflation expectations. Sharper Fed interest rate cuts today might well mute the housing price collapse, at least in nominal terms. However, if the Fed should ease too far, too fast, it could get hit by a boomerang a couple of years down the road, in the form of sustained higher inflation.

For the Fed, two to three years is the medium term, and it matters. For many financial market participants, two to three years is an eternity, and it does not matter.

Did markets complain when third-quarter US gross national product came in at (an annualised rate of) 4.9 per cent, when the economy’s trend growth rate is probably only half that? Did markets whine about the Fed’s misreading of the economy when it “allowed” growth to slip into a boom? Other than a few internet bloggers who think we are heading for inflation Armageddon anyway, it is hard to find too many complaints about the third-quarter output overshoot.

Let us face it. Most investors think a good central bank should always drive as fast as it can above the economy’s speed limit without crashing or breaking the inflation speedometer. Never mind inflated asset prices and higher inflation expectations that sow the seeds of a later crisis. As long as the benefits are here today and the risks materialise only in the future, the typical “streetwise” investor wants to see the central bank keep its foot on the gas pedal.

Unfortunately, we live in an era where trend US productivity growth is clearly down and the housing bubble could be deflating for years.

We are no longer in the technology boom years of the 1990s Greenspan era. No matter how much the Fed steps on the gas pedal, it is going to be hard to keep US trend growth much above the 2 per cent levels Europeans and Japanese have come to think of as normal. With baseline growth lower than it was 10 years ago, it takes less to push the economy into recession.

This is hardly a fun message for the Fed to have to deliver, particularly when markets seem to believe that central banks are virtually omnipotent, at least when it comes to ramping up year-end bonuses.

Indeed, most of the Fed’s bad reviews of late come from having to tell markets that, in some years, returns and bonuses are going to be weak. Epic productivity growth spurts do not last for ever. Housing booms often end in busts. When credit risk spreads collapse, they are likely to rise again.

Yes, Fed communication could be improved, particularly by announcing decade-long inflation targets that would give greater clarity to Fed objectives. But as long as trend growth stays weak and housing prices keep dropping, great clarity alone is not going to make markets happy.

Markets do not want to see academic robes on the Federal Open Market Committee; they want Santa Claus suits.