The Fed’s stealth monetary ease
Banks took more than $50 billion from the European Central Bank on Wednesday in the first offering since it, the Federal Reserve and other major central banks slashed the cost of borrowing dollars in response to a worsening euro zone crisis. The high volume of emergency borrowing was seen as a sign that some of the region’s banks are having problems obtaining dollar funding.
This means that, as our friend Mike Derby aptly predicted, the Fed’s balance sheet, currently around $2.8 trillion, will show a big increase when its weekly custody holdings figures are released on Thursday.
If one believes, as the Fed does, that the extent of unconventional monetary stimulus depends on the stock of assets the central bank holds rather than the “flow” of its interventions in Treasury and mortgage bond markets, then this amounts to a defacto monetary easing – about 1/12 of the Fed’s $600 billion QE2 bond-buying program.
Still, given that the move is a reaction to market tighteness, the overall economic impact will likely be more subdued, argues Alan Levenson at T. Rowe Price:
We do not expect the Fed to sterilize this operation, so that the expansion on the asset side of the Fed’s balance sheet (central bank liquidity swaps) will be offset by an increase in reserve liabilities. Technically, the increase in bank reserves represents an increment of “credit easing.” We view it as less potent than outright asset purchases, however, as it is a response to financial market dislocation (market-based tightening of monetary policy) and will dissipate as Europe’s interbank funding markets re-normalize.
George Goncalves at Nomura, for his part, was relieved that at least the stigma of such borrowing appeared to have been removed.
We view this as a positive first step. It leads a string of potential policy actions as authorities attempt to break the negative feedback loop from the eurozone and limit contagion back to the US. It will be a bumpy ride but this is encouraging news.
Still, he did not see such emergency liquidity measures as a sustainable solution to the underlying crisis.
Today’s action certainly changes the direction of funding stress, but it is not a game changer as it was in 2008-09. The problems facing USD funding markets are centered on counterparty risks because of lack of confidence about the EU situation and EU banks. Although this event should eventually motivate speculators to close their short positions in LIBOR/FX basis market, which should normalize these markets, it’s an EU story with concerns about sovereign and bank solvency in that region still unresolved.