Another Perspective on the Tools the Central Banks Have

The following from Bloomberg gives another perspective on the tools that the central banks have at their disposal.

As global credit markets petrify, central banks are playing ``Whac-A-Mole'' with the hammer of overnight funds to bash down short-term interest rates. At least the ridiculous claims that the subprime crisis is confined to the U.S. mortgage market have subsided.

The Federal Reserve and the European Central Bank are trapped between the devil of inflation and the deep blue sea of the global money markets. The waves that carry billions of dollars and euros between financial institutions every day have been becalmed by concern about, well, take your pick from a laundry list of worries, all of which signal fear ousting greed.

If there's one takeaway from recent events, it's the reminder that the potency of global capital can leave central banks powerless. Bank of America Corp.'s $2 billion investment in Countrywide Financial Corp., the biggest U.S. mortgage lender, may have done more to stabilize financial markets than the hundreds of billions of dollars of short-term funds supplied by the Fed and the ECB.

The ensuing dilemma is simple to enunciate, much harder to resolve. Bow to pressure at next month's policy meetings, with the Fed cutting and the ECB holding fire, and central banks risk accusations of bailing out bad lenders. Keep U.S. rates on hold and raise euro rates, and they will be charged with fiddling while securities burn.

The Fed is under the most pressure to prioritize the needs of borrowers and lenders. Rates in the futures market show traders now see just a 21 percent chance that the key rate will be left at 5.25 percent by the time the Fed's next policy meeting ends on Sept. 18, down from 92 percent a month ago.

After a slow start in responding to the surge in money- market rates earlier this month as banks hoarding capital stopped lending to each other, the U.S. central bank has shown some nifty footwork in trying to dodge the rate-cut bullet.

It started by reducing the cost of emergency funds at its discount window. That borrowing source, though, has provided a weekly average of just $52 million this year when seasonal credit to small institutions in agriculture or tourism is excluded. The most it has been tapped for in the past five years is just $785 million, though almost $12 billion was drawn down following the Sept. 11 terrorist attacks.

So on Aug. 22, the four largest U.S. banks stepped up, with Citigroup Inc., Bank of America, JPMorgan Chase & Co. and Wachovia Corp. each taking $500 million of funds at 5.75 percent, well above the 4 percent rate that the overnight Fed funds rate closed at that day.
The implied message to the smaller finance houses is that there shouldn't be any stigma attached to borrowing at the penalty rate if you need to.

You can imagine the telephone conversation with the Fed that inspired such munificence; not dissimilar from the 1998 chat that brought about the rescue of Long-Term Capital Management LP. A cynic might also wonder whether Bank of America's $2 billion vote of confidence in the U.S. mortgage market by buying preferred stock in Countrywide was similarly Fed-inspired.

All of this is evidence that the Fed will keep pulling new tricks to avoid cutting its key overnight target rate of 5.25 percent, either before or at its Sept. 18 gathering -- and will rally U.S. financial institutions to its cause, marshaling the forces of capital by reminding them that their interests in maintaining market order are 100 percent aligned.

The Fed doesn't want to be bullied into changing course; it must also be acutely aware that a policy response would stoke concern the situation is even worse than it appears -- not to mention guaranteeing that Chairman Bernanke would be known as ``Helicopter Ben'' for the rest of his career.

The ECB has a more immediate problem, though its solution is likely to be different. Although President Jean-Claude Trichet repeatedly says ``we never pre-commit'' to rate changes, he has boxed himself into a corner by presaging each of the eight increases in the current tightening cycle with the words ``strong vigilance,'' a phrase he repeated earlier this month.

Expectations are justifiably high that its key one-week rate of 4 percent will increase when policy makers next meet on Sept. 6. And the ECB, sired as it was by Germany's Bundesbank, will be even more reluctant than the Fed to be perceived as pandering to the interests of the market rather than serving the needs of the economy.

The trouble is, money-market rates are already punitively high, with the cost of borrowing euros for three months climbing to 4.78 percent today, the most expensive since May 2001 and up from just 4.23 percent a month ago.

The central bank has tried to steer that rate lower, holding a special auction of 40 billion euros ($54 billion) of 91-day funds yesterday. It also said ``the position of the governing council on its monetary policy stance was expressed by its president,'' a signal that its policy course won't be diverted.

So the ECB's likely path is to enforce a higher one-week benchmark rate next month while continuing to feed the money markets with longer-dated funds.

The modern rules for central banking are still being crafted and honed. There's no guarantee that their evolution will keep pace with the turbocharged rate of change in financial markets where the prospect of fabulous riches motivates insane levels of creativity and entrepreneurship.

The recent turbulence suggests one big change may be needed. Ignoring house values and the stock market when setting monetary policy looks increasingly unsustainable when they play such a vital role in determining the economic outlook. So when central bankers hold the equivalent of their annual picnic at Jackson Hole, Wyoming, at the end of the month, the topic of asset prices should be high on the agenda.