In this situation it is first of all up to the USA to support the international financial markets, as this is were the problems arose. Apart from a rate cut by the Fed, another way to calm the financial markets would be a more active part for institutions like Fanny Mae and Freddy Mac by buying commercial papers to a significant extent and being allowed to become active in segments of the mortgage market which are closed at the moment for them. This would help to get the normal credit market functioning again in a more satisfactory way as it is the case now. A further strategy already applied e.g. in Canada would be to transform commercial papers to a larger extent into floating notes with a variable interest rate; a consortium of private banks would have to take charge here in cooperation with the central banks.
With regard to the ECB, a postponement or even abandonment of a rate hike would be supportive to stabilise the financial markets and reduce the danger of spreading the financial problems to the real sector.
In the longer run there is no doubt that financial supervision has to be improved almost everywhere. Also the topic how central banks should deal with asset price inflation has to be tackled more intensively in the future. However, at the moment the most urgent problem to solve is to get the normal credit business functioning again.
Recent events have led me to downgrade both the growth outlook and the risks around it. The possibility of a credit crunch that slows down economic activity has increased significantly, and therefore a thorough analysis is needed before deciding on the future course of rates. Likely a few months of data will be needed to assess the impact of recent events, and thus I would argue for rates on hold with a neutral bias. In this environment one cannot rule out a scenario where confidence in markets deteriorates sharply and rapidly to the point of damaging the real economy, and thus rate cuts may become necessary. Therefore, monetary policy must keep all options open, thus my neutral bias. It is clear that money markets are not functioning well despite the liquidity injections, that there is still plenty of mistrust about counterparty risk and that rollover risk in the ABCP is still high. With financial conditions having tightened through the decline in stock prices and the spike in 3m rates, the most important consideration for a central bank in this environment should be to "first do no harm', and that argues for a wait and see, completely open minded attitude. Let's not forget that hiking cycles are typically planned and cutting cycles are typically a reaction to unforeseen events. The current situation argues for prudence.
Another point I would like to make is that the current crisis has been a liquidity crunch in the midst of an "excess liquidity" environment. Clearly, this has shown that the amount of money in circulation has become a very poor indicator of "market liquidity", which is driven by risk attitudes and leverage. It is interesting to see that the crunch is as strong in Europe as in other areas, despite the ECB's special focus on monetary developments.
José Luis Alzola
GDP growth moderated to 2% annualized in 1H, suggesting that past interest rate increases have managed to clamp GDP growth roughly in line with its potential pace. Financial conditions tightened significantly in 1H, reflecting another 50-bp short-term rate increases and a 75-bp increase in private-sector bond yields. All this was bound to maintain GDP growth around trend in coming quarters, notwithstanding the continued support from a dynamic global economy. The events of the past few weeks – in particular, the rise in term money-market rates and the widening of credit spreads – implies a further significant tightening of financial conditions, creating meaningful downside risks to growth. Against this background, further rate hikes – which run the risk of boosting term money market rates more – are difficult to justify, unless there were an inflation problem.
But the fact is that inflation appears well under control. Recent readings show that, far from accelerating, core inflation probably is edging down again, once the impact of higher indirect taxes and administrative prices earlier this year has been absorbed. This is not surprising. First, import and, in general, pipeline inflation pressures have eased considerably since mid-2006, partly thanks to the strength of the euro but also to more stable commodity prices than in previous years. More importantly, wage growth remains contained. In Germany (where the risks of a significant pick-up are higher), contractural wages accelerated to just 1.8% Y/Y in 2Q (and 1.5% in June), leading to a 1.3% gain thus far this year. This is the same as in the three previous years of declining unit labor costs. In other major countries, wage growth thus far this year is lower than in 2006 on average. Despite a declining unemployment rate, there are no signs whatsoever of building wage pressures.
Aside from these fundamentals, the current financial market environment advises caution in monetary policy. The ongoinmg re-pricing on risk assets probably is desirable for the long term (i.e., to avoid further excesses) but it does have an economic impact. Moreover, without the proper treatment from policy-makers it can easily feed into a very disruptive process. Thanks to low inflation and inflation expectations and the fact that interest rates already are in line their long-term neutral level, the ECB has the “luxury” of adopting a wait-and-see approach, possibly for a prolonged period of time, as the correction in financial markets continue to unfold.
Money market conditions are still under pressure. Although ECB injection have been successful in normalizing the O/N rates, financing conditions remain abnormally tight on longer lending duration. Counter-party fears are still in place eroding liquidity and at the end tightening credit conditions. Raising key rates in such conditions would represent a considerable risk and would obviously go against recent and reiterated efforts of the Central bank to counter the liquidity crisis. Eurozone economic growth is slowing down. So far nothing indicates substantial downside risks to the regional growth outlook. But risks coming from outside, the US especially, have increased once again quite significantly in recent weeks. In such conditions the best thing to do is first to continue to provide liquidity to the banking system second, to adopt a wait and see attitude before having more information on the diffusion of the current liquidity squeeze to the real economy.
A central bank role in a situazion of strong market tension is to prevent liquidity problems from jeopardizing the solvency of financial intermediaries: the injection of funds throughout August was the appropriate measure to take. The propagation of shocks from the US through Asia and Europe, and across different classes of intermediaries, has provided an important test for the effectiveness of central banks intervention to preserve financial stability. No doubt that there will be a number of lessons to be learnt from a careful analysis of the financial turmoil in the last few weeks. It may take some time however to learn whether the crisis has been accompanied by some deterioration of the general economic outlook for growth, which remain overall positive in spite of adverse news from a few indicators. Moreover, the question is whether the crisis is completely over. Even if one believes that the overall monetary stance of Europe is not neutral yet, and further increases are required, there is no compelling reason to implement further adjustment of rate at this stage.
There is an option value in waiting. Nothing in the inflation outlook suggests a great urgency to move rates either way and as uncertainty increases the best action is a wait and see for the 'classic' monetary policy tool coupled with 'vigilance' concerning systemic stability.
Even assuming that deft central bank action prevents the credit crunch in the banking sector to spill into the real economy credit conditions for private households and companies are likely to tighten. Hence, against the background of continuing uncertainty in financial markets and the prospect for credit tightening for the real economy, the case for further ECB rate increases has weakened substantially.
The ECB will ultimately have to base its decision on fundamentals and its assessment of the impact of financial market turmoil on the medium turn outlook for inflation. The obvious link is the potential drag on growth. The current situation differs from a typical corporate- or household-led slowdown as the shock to the economy is coming from its heart – the banking sector. This complicates the analysis as data similar to those which track the household or corporate sectors are not available. The Euro area banking sector has significant exposure to the US economy. Recent events are likely to result in banks raising the cost of borrowing and in some instances reducing the supply of credit. The latest ECB lending survey suggested that banks intended to tighten lending criteria. Recent financial turmoil and increased regulatory scrutiny will reinforce this trend, lifting the cost of borrowing and restraining lending to firms and households. 25 per cent of borrowing by euro area fims is short term, the cost of which has risen significantly. Long term borrowing costs are also on the rise given the current widening in corporate spreads. The increase in short term and medium term borrowing costs, if they remain at present levels, would be equivalent to a raising of the policy rate of around 50bp.
The euro area is highly integrated with the global economy via trade, investment and financial linkages. This suggests scope for a drag on the economy should the US slow further as a result of the housing adjustment.
Confidence is a key transmission channel, which our analysis suggests will be adversely affected in the short term. The stock market decline is the key driver, but businesses are also likely to adopt more cautious assessments of the economic outlook and could delay hiring and production plans.
All in all the transmission channels reviewed suggest somewhat weaker growth in the medium term and thus warrant the ECB moving to a wait-and-see mode.
The role of a lender of last resort is to provide generous liquidity, but at a price. Consistently, the ECB's approach so far, which consists in injecting liquidity without reducing its price, seems appropriate. The discount rate is a different issue. Given recent news about Eurozone growth, and given the high level of the euro, there is little risk on inflation and I do not think rising interest rates would be the right thing to do. Cutting it would confuse the market since it would appear as a response to the present financial crisis rather than as a way to achieve ECB's main objective of price stability. It would also contradict pre-crisis ECB's communication. Hence I think it would be wise to keep the interest rate unchanged this time.
Despite the liquidity injections by the ECB and other central banks over the past several weeks, the tensions in the money markets continue. While banks have access to plenty of base money at the official rate, they are reluctant to lend to other banks. This has pushed interbank interest rates for longer maturities higher, even though the official interest rate has remained unchanged. In addition, investors shy away from buying asset-backed commercial paper issued by banks, their conduits, and non-financial corporations, pushing these borrowers into bank credit. Lenders distrust borrowers because many banks and their conduits are facing losses in the US mortgage market. Central banks' liquidity injections are needed to help those banks who don't get the funds in the interbank market, but they don't solve the underlying problem. Confidence will only return once it becomes clear who is facing what losses. This will likely take a while.
Apart from providing temporarily more base money, should central banks also change the rates at which they provide it? The Bank of Japan last week decided to shelve the rate hike that had looked likely only four weeks ago. The Federal Reserve has cut the largely symbolic discount rate and changed its risk assessment, thus paving the way for a possible cut in the Fed funds rate. The ECB-Council will have to assess whether and, if so, to what extent the tensions in the money markets affect the outlook for growth and inflation. The key question here is whether the losses banks are facing in US mortgages affect their ability and willingness to extend credit to domestic households and companies. With some banks facing major losses, this cannot be excluded.
In my view, the refi rate should be kept unchanged in September. Postponing the planned rate hike can be justified both with the economic and the monetary pillar of the ECB's policy strategy. With recent events, downside risks to global growth have increased. Also, the second-quarter GDP data for the euro suggest some slackening of domestic growth. Moreover, with banks likely to tighten credit standards, a further slowing of credit and, eventually, money growth has become likely. Thus, a decision to keeps rates unchanged could be easily justified within the usual two-pillar framework.
As proposed by Anne C. Sibert and myself, the key thing the ECB should do is act as market maker of last resort (MMLR), the 21st century version of Bagehot’s lender of last resort (see » Blog entry 1; » Blog entry 2; » Blog entry 3; » Blog entry 4; » Blog entry 5). This directly and most effectively addresses the major problem faced by private financial institutions: the sudden illiquidity of many assets previously deemed to be liquid. The ECB can do so by expanding both the set of eligible securities it accepts as collateral in its liquidity-creating repos and at the Marginal Lending Facility (the ECB’s discount window for collateralised loans to banks) and the set of eligible counterparties. Both enhancements should be conditional. Securities acceptable as collateral to the ECB in repos or at the discount window, or for outright purchase, should include private securities rated lower than the current minimally acceptable rating (A-); non-investment grade securities (‘junk’) should be acceptable, at a proper price and haircut, as collateral and for outright purchase. A more detailed proposal by Anne C. Sibert and myself on how to price those purchases by the ECB of illiquid securities is contained in my blog ( entry 4) . Through some combination of the interest rate charged on collateralised loans, the price at which the ECB offers to value the illiquid securities either as collateral for lending or for outright purchase, and the ‘liquidity’ haircut applied to his valuation, moral hazard can be minimized. Instead of acting as MMLR for illiquid securities, the ECB has simply increased the scale of its liquidity enhancing operations for normal times (when markets are orderly). This has at best marginally increased the liquidity of already liquid assets, and has done nothing to address the liquidity crunch directly – an example of too much of the wrong thing and nothing of the right thing. The set of eligible counterparties at the Marginal Lending Facility should be extended to include all those who are willing to satisfy standards of prudential behaviour specified by the ECB. This would, in all likelihood not just involve reporting obligations sufficient to create the transparency required to allow the ECB to form a view on the institutions’ total exposure, but also restrictions on permissible exposures, minimum capital requirements etc. Even for those non-bank institutions that would not wish to avail themselves of this direct discount window access in exchange for prudential oversight and restrictions, the days of effectively no supervision and regulation and minimal reporting obligations should be over. It is time that hedgefunds, private equity funds, ‘conduits’ and SPV of any and all kinds (and indeed sovereign wealth funds) be brought within a proper, light-touch regulatory and supervisory framework, preferably one established for all of the EU, not just the Eurozone. This regulatory function should not be performed by the ECB, for two reasons. First, it should be for the EU as a whole, and not just for the 15 full EMU members. Second, the ECB has to high a degree of independence (because of its monetary policy function) to be a proper, substantively accountable financial market and financial institution regulator/supervisor. It would, of course, have to work closely with the regulator. This regulatory framework should be externally imposed: self-regulation means no regulation unless the threat of the imposition of external regulation causes the self-regulated industry to act the way it would under externally imposed regulation. In that case you may as well have the externally imposed regulation. It is key that the ECB not bail out or financially support financial businesses, be they commercial banks, saving banks, investment banks, hedge funds or private equity funds, unless this is absolutely necessary to safeguard key financial markets and other valuable social mechanisms (the payments, clearing and settlement systems for goods and services and for securities). I can think of no individual commercial bank in Germany or Europe at large, whose survival as a going concern is essential for the soundness of the intermediation, payment, clearing and settlement systems. The ECB should not follow the Fed’s example and cut its discount rate. The ECB’s Marginal Lending Facility currently charges a 5.00% rate, 1.00% above the ECB policy target rate, the Main Refinancing Operations Minimum Bid Rate, which stands at 4.00%. Following the Fed and bringing down the Marginal Lending Facility rate would simply be an inframarginal subsidy to those already able and willing to borrow at the Marginal Lending Facility because they have the right collateral. A sub-topic of particular interest is the question: Should the ECB alleviate money market stress by injecting funds with longer maturities? Answer: Maturity is not the main issue. Liquidity is. Securities can have infinite remaining terms till maturity yet be highly liquid. That said, the Fed has extended the term for which banks could borrow (against suitable collateral) at the discount window from overnight to 30 days. That clearly makes sense during times when so many financial institutions are still wearing plastic underpants. Apart from that, rediscounting low-grade, high-risk illiquid collateral (which may or may not have a long maturity as well) is the best contribution the ECB can make to financial stability.
I think in the present situation the ECB should take all technical measures necessary to provide enough liquidity to the money market. This has nothing to do with protecting banks from the consequences of too risky decisions taken in the past. The aim is to solve the confidence crisis on the money market which can (due to the lack of transparency) strike banks without reason / through no fault of their own. Consequently, it is right to use the whole spectrum of tender operations (quick tenders, weekly and longer-term refinancing operations) for liquidity management in order to normalize interest rates. Since the 3-month EURIBOR was abnormally high and given the fact that the recent lack of demand for commercial paper affects the same maturity segment, the additional tender announced yesterday seems to be the right remedy.
However, after a long period of very loose monetary policy around the globe, central banks are in a predicament with regard to cuts in key interest rates and their next moves need to be carefully considered. Basically, there is a moral hazard problem: if banks think in advance that they can rely on central bank help in an emergency, the incentive shifts towards more recklessness, thereby actually increasing crisis vulnerability. Possibly for this reason the Fed chose as a first step to lower the discount rate rather than the mainstream fed funds rate. Like the Fed, the ECB could now theoretically also lower the rate for the marginal lending facility, bringing it closer to the minimum bid rate. This would help to curb fluctuations in the overnight rate. As, in my view, technical liquidity assistance and the fundamental direction of monetary policy cannot be viewed as two completely different creatures, I do not think an ECB rate hike at the present juncture would make sense.
I continue to think that another hike in interest rates is not necessary in the current conditions. The key indicators behing that view suggest that the inflation outlook remains begnign. The Eurozone economy has now reached a cruising altitude of about 2.5% for GDP growth, and capacity utilization rates, whilst tight on equipment, do not suggest labour shortages are anywhere close to the levels they reached in 2001. M3 growth is now essentially due to the foreign sector (strong foreign demand for euros) and corporates loans (associated to strong investment -a good thing!). And oil prices have recently retreated while the strong euro continues to offer some good protection against imported inflation. The recent turmoil on credit markets does not in itself prohibit a hike by the ECB, but such a move would surely difficult to understand for international investors.
The generous liquidity injections by the ECB are the right approach. They are ensuring that liquidity provision is not a worry for market participants, so that they can focus their investment decisions on the risk characteristics of the assets, not on whether they will be able to fund themselves in the near future.
The ECB Council’s decision to stick to the rules – that is basing its policy on the results of its policy strategy analysis, which recommends raising rates further – deserves applause. Credit and money growth are still unacceptably high, representing a serious threat to the value of the euro: either by provoking consumer price inflation or by bringing the economy’s overall debt-to-GDP ratio to unsustainable levels. The unfolding credit crisis is the direct outcome of an overly expansionary monetary policy delivered in the past. Too much credit and money supply at too low a level of interest rates are at the heart of the malaise. Keeping rates artificially low, or lowering them even further, will not solve but aggravate the problem.
Adding liquidity and raising rates would be a strange mix and confuse the distinction between lender of last resort and guardian of price stability. If things settle down, it's easy enough to return to rate raising mode later on. Strong vigilance should not be treated as an absolute guarantee that rates will go up and, if it is, then perhaps a new communications approach is required.