Banks leap in to add liquidity - By throwing billions into the market, they risk hurting their own inflation

Banks leap in to add liquidity - By throwing billions into the market, they risk hurting their own inflation
By Eoin Callan in Washington and Jamie Chisholm in London
Copyright The Financial Times Limited 2007
Published: August 11 2007 03:00 | Last updated: August 11 2007 03:00


The message from central banks to investors only four days ago was: "Trust us. We've got it all under control." But since then, the tightness in credit markets has developed into a blockage in the overnight flow of money between financial institutions in Europe, the US and Asia.

Central banks have been forced to inject massive doses of liquidity in excess of $100bn into overnight lending markets, in an effort to ensure that the interest rates they set are reflected in real-time borrowing.

The European Central Bank has acted most aggressively, lending €61bn to institutions to tide them over the weekend after injecting €95bn on Thursday. The Federal Reserve said yesterday it was "providing liquidity to facilitate the orderly functioning of financial markets". The New York Fed agreed to accept as collateral more than $30bn of mortgage-backed securities, which are being shunned by investors. The Bank of Japan injected Y1,000bn ($8.5bn).

The goal of the banks is to prevent overnight interest rates rising far above the level they have determined to be conducive to growth and low inflation. In the US, the federal funds rate opened yesterday at 6 per cent, the highest in six years, before the Fed acted to bring it down. The Fed is protecting an interest rate of 5.25 per cent, the ECB a rate of 4 per cent, and the BoJ an overnight target of 0.5 per cent. But all have mused recently on the prospect of raising rates.

By moving to lower rates and calm fears of a credit crunch, the central banks risk undermining the message that they may have to lift the cost of borrowing in the near future to address inflationary pressures and wider macroeconomic factors.

So far, central banks are all trying to tread a line between providing whatever liquidity is needed at current rates on the one hand and changing their interest rate plans on the other.

The ECB faces the most immediate pinch, as it has already signalled that it intends to raise rates next month. "The contradiction of raising rates and supplying emergency liquidity will not be lost on the ECB," says Alan Ruskin, a currency strategist at RBS Greenwich Capital.

"If this crisis of confidence in the money market continues in the run-up to the next ECB meeting, it will make a September rate hike much less of a certainty."

But Amit Kara, a UBS economist, said there was no contradiction in the ECB adding liquidity to the market while at the same time letting investors believe it would raise interest rates in the autumn.

"One is about a short-term lubrication and one is about long-term policy," he said.

There were signs yesterday that while the intervention was having the desired effect, it had not yet restored an equilibrium and might continue next week.

"We haven't seen the end yet. The tightness in money markets is spreading and affecting rates beyond just the overnight rate. The ECB has not extinguished the crisis of confidence," said Lena Komileva, group G7 economist, at Tullet Prebon.

"The irony is that the ECB is doing what they should by injecting liquidity, but by doing so they are underlining for investors that credit problems that arose in the US are causing serious distress in Europe," she said.

But most central bank economists defended the actions of the ECB, Fed and BoJ as prudent. The rush to shore up markets was imperative rather than optional, they said.

The advent of deep and liquid capital markets has been credited by policymakers with giving the current global economic expansion the flexibility needed to adapt to adversity.

"If risk aversion remains high, banks and primary dealers may hoard cash, preventing its flow into the broader financial markets," says Bruce Kasman, chief economist at JP Morgan.

"Under this scenario, the stability of the financial system would be threatened along with the macro-economic outlook," he says.

"The Fed along with other central banks would be quick to respond by adjusting the path of policy they are currently following."