Central bankers are supposed to be boring and predictable. But last week the rich world's monetary authorities stunned financial markets with a dramatic, joint plan to ease the liquidity squeeze in global money markets.
America's Federal Reserve, the Bank of England, the European Central Bank (ECB), the Bank of Canada and the Swiss National Bank all pitched in. The central banks of Sweden and Japan said they, too, were watching developments and would act as necessary. All told, it was an impressive show of central-bank coordination.
Financial markets have been seizing up for weeks. The spreads between the federal funds rate and the prices charged by banks to borrow from each other have widened dramatically since early November. By some measures, the financial system is more blocked than it was in September. And it has long been clear that central banks' attempts to sort out the mess were failing. The quarter-point cuts in its federal funds rate and discount rate on Dec. 11 were followed by a steep sell-off in the stock market. This was only partially reversed the next day after the central-bank effort was announced.
Essentially, the central banks have borrowed each others' best ideas for how best to ensure that liquidity gets where it is needed. And they have also, in effect, acknowledged the international nature of the liquidity squeeze by promising to provide reciprocal currency-swap lines.
The Fed made the most dramatic changes. It introduced a "term-auction facility" through which all banks eligible to borrow from the discount window could bid for one-month money. The first two auctions were to be Monday and Thursday of this week, with $20 billion to be sold at each. Two more are to follow in January. The Fed also announced temporary swap lines with the ECB and the Swiss National Bank, worth $24 billion, allowing those banks to lend dollars to banks pledging euros or other currencies.
The Bank of England promised to inject more money into the markets, increasing its two forthcoming term auctions from $5.8 billion to $23 billion each time. The hope is that by extending the maturity of central-bank money, broadening the range of collateral against which banks can borrow and shifting from direct lending to an auction, the central bankers will bring down spreads in the one- and three-month money markets. There will be no net addition of liquidity. What the central bankers add at longer-term maturities they will take out in the overnight market.
In some ways, the announcement is a triumph for the ECB. Both the Fed and the Bank of England have shifted away from the familiar tools of a lender-of-last resort -- providing funds freely to institutions at a penalty rate. They have moved closer to the ECB's approach of auctioning funds to a broader set of actors against a wider range of collateral -- in effect becoming a market of last resort.
But there are risks. The first is that, for all the fanfare, the central banks' plan will make little difference. After all, it does nothing to remove the fundamental reason investors are worried about lending to banks. That is the uncertainty about potential losses from subprime mortgages and the products based on them, and -- given that uncertainty -- the banks' own desire to hoard capital against the chance that they will have to strengthen their balance sheets. Nor is the shift from direct lending to auction sure to work. Furthermore, central banks will now be more intricately involved in the unwinding of the credit mess. Since more banks have access to the liquidity auction, the central banks are implicitly subsidizing weaker banks relative to stronger ones. By broadening the range of acceptable collateral, the central banks are taking more risks onto their balance sheets.
Set against the dangers of all-out financial seizure, those risks seem worth taking. More important, if they succeed in even modestly loosening the money markets, they will reduce the pressure on central banks to use the broader tool of lower interest rates.