Central banks are obviously getting frustrated and effectively desperate in dealing with a most severe liquidity crunch that has gotten significantly worse since August. Even last week’s coordinated announcement of central banks monetary injections has done little so far in reducing the Libor spreads (at maturities from two weeks to 3 months) relative to overnite policy rates, relative to government bonds of matching maturity and relative to the Overnite Index Swap (OIS) rate. The three month Libor versus policy rate differential is still 69bps in the US, 95bps in the Eurozone (its highest level in years); and 93bps in the UK.  We will see the effect of the first of the TAF auctions by the Fed on Wednesday but there is little reason to believe – based on current spreads – that this first auction has eased liquidity conditions in interbank markets. As pointed out by Cecchetti the kind of new auctions at term horizons that the Fed is performing now have been performed by the ECB for a long time; and in the Eurozone such auctions has so far miserably failed to reduce the various Libor spreads; so why would these new instruments be effective in the US if they have not been effective in the Eurozone?

So central banks are now becoming even more creative in dealing with the liquidity crunch and starting to do the kind of stealth policy rate reductions that they performed last August and September. The ECB just announced a special liquidity operation that will allow financial institutions to borrow for two weeks unlimited amounts at a rate of 4.21% (close to its policy rate of 4%); the two-week euro Libor had been 4.9% before the announcement. So the ECB is providing a temporary monetary policy easing of 70bps for a two week period.

The operation is highly unusual and heterodox; and while getting creative in dealing with liquidity crunches may be appropriate this action signals some desperation on the part of the ECB. The problem is that the ECB is the only G7 central bank – apart from the BoJ – that has not reduced at all its policy rate. And since most financial and other private contracts are indexed to Libor, an average Libor that is about 100bps above policy rates it is equivalent to the ECB having raised its policy rate by 100bps in the last few months. So not only the ECB has not reduced its policy rate in spite of major signals and risks of economic slowdown in the Eurozone (oil price shock, strong euro hurting European competitiveness, effects of the US sharp slowdown, liquidity and credit crunch, sign of a slowdown in economic activity, beginning of a deflation of housing bubbles in Europe); it has effectively increased its policy rate by 100bps as Libor – rather than the policy rate – is the relevant cost of capital for the financial system.

If the ECB wants to deal with a liquidity crunch that is not only due to the year end "turn" (as Libor spreads are 100bps even at 3 month maturities) it should not directly manipulate market rates at two weeks maturities – as it has effectively done with this temporary two week monetary policy rate easing, i.e. lending at 4.21% when market rates were 4.9%). This latest operation is effectively a manipulation of market rates as – instead of using market auctions to determine the price of liquidity – the ECB effectively is promising to provide unlimited liquidity for two weeks at a rate well below market rates. Call it effectively a cut in the policy rate for a temporary two weeks period. As commentators in the FT put is this is a big Chrismas subsidy by the ECB to financial markets:

“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”.

And since the ECB has estimated the demand for liquidity at over 260 billion euros this operation is potentially quite a subsidy to financial markets. The ECB should instead seriously consider cutting its policy rate below 4% as the downward economic risks to growth are now serious and the credit and liquidity crunch is getting extreme. Even the BoE and the BoC did a cosmetic but at least initial 25bps policy rate cut.

At the same time the Fed appears to have started again the stealth Fed Funds easing that it did perform in August and until the September 18^th Fed Funds 50bps cut. Indeed, right after the 25bps cut in the Fed Funds rate on December 11^th the Fed has started to do open market operations at rates below the new Fed Funds target rate of 4.25%. On Wednesday December 12^th the Fed did a $12 billion 8 day repo at an effective rate of 4.066, i.e. 19bps below the Fed Funds rate (with accepted collateral being Treasuries). Then on Thursday December 13^th it did a $6 billion 14 days repo at a rate of 3.95% (with accepted collateral being Treasuries); on the same day it did another $10 billion 14 days repo where average rate on the component backed by Treasuries was 4.01% and the rate on component backed by Agency debt was 4.27% (both rates being well below the 7 day Libor); a third overnite repo that day occurred again at rates below the Fed Funds for the component backed by Treasuries. Then yesterday Monday December 17^th the Fed did another overnite repo where the rate on the $7.5 billion backed by Treasuries collateral was 3.95%, i.e 30bps below the overnite Fed Funds rate of 4.25%.  

What does this means? Simply that, like in August and September the Fed is now doing stealth reductions in the effective Fed Funds rate as it is lending every day significant amounts of liquidity at rates well below the target Fed Funds rate of 4.25%.  And in spite of such stealth reductions in the Fed Funds rate the liquidity conditions in money markets remain as strained as ever. It is true that the average effective Fed Funds rate has remained very close to the target rate of 4.25% for the last week; this is different from August-September when the effective Fed Funds rate was on average below the target rate. But some financial institutions – the few and lucky ones having access to the Fed’s repos – are now borrowing at below the target Fed Funds rate not only overnite but also at maturities of one week and two weeks when the Libor rate on those horizons is well above the overnite Fed Funds rates. Thus, the latest repos of the Fed are done on terms even easier than the those just announced by the ECB: the ECB is providing unlimited liquidity for two weeks at a rate close to its policy rate (but 70bps below equivalent market rates); the Fed is providing more limited but significant liquidity at rates well below its policy rate not only for overnite operations but also for operations with an horizon of one and two weeks.

Of course, as it has been argued in this forum since last August when the crunch first emerged, this severe liquidity crunch would get worse rather than better, is due not to illiquidity alone but also to insolvency, widespread lack of trust and counterparty risk, un-measurable uncertainty, wrong incentives and information asymmetries in financial markets and the existence of a shadow non-bank financial system where you have a huge number of non-bank financial institutions that are severely illiquid and do not have direct or indirect access to the Fed’s open market operations, discount window, auctions and other forms of lender of last resort support. This crisis represents the first crisis of financial globalization and is the most severe financial turmoil hitting advanced economies in the last twenty years. But central banks are treating this liquidity and credit and solvency crisis and crunch as if it was a run-of-the-mill mild liquidity crisis – like the one that occurred during the near collapse of LTCM.

And the central banks – the Fed in particular – have been behind the curve for over a year now. The Fed totally underestimated the housing recession arguing – like most market folks – that this was a temporary slump that would bottom out by the end of 2006 (sic!); it kept on saying throughout the winter of 2006 that the sub-prime problem was a niche and contained problem when it was not just sub-prime mortgages but also near prime and prime and excessive and reckless lending and leverage across the entire financial system; it kept on arguing that the housing slump would not affect other sectors and would not lead to a more severe economic slowdown that is in full swing now; it underestimated the risk of broader contagion to the financial system and ended up being literally surprised when the liquidity and credit crunch hit in the summer time; it then it deluded itself in believing that this crunch was temporary and that Fed easing would resolve it; and it was then surprised (as Kohn admitted in its last speech) when the crunch got worse rather than better in the fall and has now gotten much worse than in August. So, the Fed has been persistently wrong for over a year now in its assessment of the economy and of financial markets.

As argued here liquidity palliatives and band aid will not work. Certainly at this point monetary policy will have very limited ability to prevent the hard landing that the US is now experiencing and a severe global economic slowdown as we are now paying the price for the credit excesses, the asset bubbles, the reckless leverage, the lack of minimal appropriate supervision and regulation of financial markets of the last few years. A sharp recession is unavoidable and necessary to cleanse the financial system and the economies from such excesses.

But the failure of central banks and the Fed to provide the appropriate diagnosis and prognosis of the crisis and now their failure now to provide enough monetary policy easing to reduce the collateral damage on the real economies of the fallout of the bust now of the biggest ever credit house of cards is worrisome. Monetary policy easing will not avoid the necessary recession and massive financial losses that will be experienced by economies and financial markets regardless of what monetary authorities do now.

This forum was the very first to argue over 17 months ago in August 2006 that this was a solvency crisis - starting with subprime and housing but bound to spread to the entire financial system - and that a recession would be unavoidable by 2007. But arguing now that a harsh medicine of monetary tightening (keeping policy rates on hold or even raising them) is the bitter and painful medicine that markets and investors need to ensure the appropriate fall of asset prices, the appropriate deleveraging of the financial system, and the appropriate and unavoidable losses is – in my view incorrect. That severe fall in asset prices, that deleveraging and reintermediation in the banking system of off-balance sheet and off-banking intermediation, those massive losses in the trillion dollar range will occur regardless of how much monetary policy easing occurs now. What central banks should worry now is the risk of a global recession; and this requires lower policy rates, not temporary monetary injections and stealth reduction in policy rates and manipulation of market rates. The time for fixing the international financial system, reforming regulation and supervision, reducing moral hazard, dealing with the mess of securitization, avoiding another asset bubble will come once the collateral damage to real economies is reduced. You don’t withhold liquidity during a five-alarm fire because of the moral hazard of fire insurance or the collateral damage to a building of excessive use of water.

Thus, I respectfully disagree with the very serious and intelligent arguments made recently by many thoughful analysts (most recently Rogoff today in the FT) that central banks should not ease as this will prevent the necessary adjustment and may cause future bubbles, more moral hazard and future inflation; these are legitimate and sensible concerns but confuse the appropriate policy response in the short run versus the medium term. Those necessary real and financial adjustments will occur regardless of that monetary easing today; and the way to prevent future excesses, bubbles and manias is to eliminate the monetary easing as soon the collateral damage to the real economies is minimized and to introduce appropriate regulation and supervision of a financial system that has run amok.

As Larry Summers put it correctly  - by warning about moral hazard fundamentalism - during a crisis you provide effective temporary regulatory forebearance and deal with the short term risks to growth. Using the hammer of tight money and regulatory crackdown to deal with systemic medium long-run excesses risks exacerbating an already severe liquidity and credit crunch whose severity monetary easing can only marginally dampen and risks causing an even more severe recession than the necessary one that will occur even in the presence of a monetary easing. Sophisticated monetary and regulatory policy will provide short-term easing while seriously and expediously redesigning a regulatory framework for the financial system that reduces future excesses and moral hazard.

This was the balanced approach to crisis resolution and prevention that those of us who were involved in the resolution of emerging market crises of the last decade took: provide large liquidity to illiquid but solvent sovereigners/countries, reduce and eventually cut off lending to illiquid and insolvent sovereigners, restructure coercively claims that needed restructuring with creative new approaches to debt restructurings and design a new long-term international financial architecture that would prevent emerging market crises in the first place and resolve them more efficiently if/when they did occur. Designing a more robust international architecture for the long run and minimizing moral hazard was not inconsistent with providing massive short run liquidity to those countries that were illiquid, willing to clean up their act and deserving of such support.

A similar balanced approach to crisis resolution and serious reform of the international financial system is required today

9am EST Update: Today's monster monetary injection by the ECB ended up being even larger than expected, amounting to 348.6 billion euros (or about $501 billion). The two-week Euribor fell a record 50bps to 4.45%. But in spite of this massive intervention it is still 45bps above the 4% policy rate of the ECB; so even with this unprecedented intervention the ability of the ECB to unclog the money markets has been only partially successful. Also note that three-month euribor rate fell 7 basis points to 4.88 percent but it is still 88bps above the 4% policy rate. Thus, while a massive injection of liquidity of $500 billion partially reduced the crunch at a short term maturity of two weeks - the one that covers the year end "turn" it has done little to nothing to deal with the liquidity crunch at a 3 month horizon. And the fact that the two week euribor is still a stubborn 45bps above the policy rate - in spite of an added $500 billion of liquidity - means that the liquidity crunch remains severe among non-bank financial institutions - SIVs, money market funds, investment banks, hedge funds - and a variety of non-depository institutions that do not have accesss to the ECB (and Fed's) open market operations and auctions. If $500 billion of extra liquidity is not enough to reliquify money market what will take to do that? Possibly nothing as monetary policy cannot address credit and insolvency problems and the deep lack of trust of counterparties that are at the core of this credit - not just liquidity - crunch.