International Monetary Fed

May 11, 2010

by Rolfe Winkler and Rob Cyran

Is the Federal Reserve pushing the limits of its authority? In re-opening swap lines to other central banks, the U.S. central bank has made another open-ended commitment to grease the wheels of banking, particularly in Europe. Containing debt contagion is a worthy goal, but such interventions have downsides — including potential inflation and moral hazard.

As European leaders raced to agree to a 750 billion euro bailout over the weekend, Fed Chairman Ben Bernanke pitched in by promising to provide an unspecified amount of dollar funding to other central banks. Some European banks, for instance, wanted out of risky securities like Greek sovereign bonds and into safer investments like U.S. Treasuries. But funding markets made that difficult, flashing signs of stress not seen since the height of the financial crisis.

To reduce this, the European Central Bank agreed to buy up Greek sovereign debt that no one wanted. Unfortunately, many counterparties wanted dollars in return — more than the ECB could provide. Enter Bernanke. By exchanging dollars for euros from the ECB, the Fed’s swap lines help unclog markets in Europe.

That’s fair enough on its face — after all, financial markets are global and the Greek debacle was already affecting the United States. But there are concerns. The first is potential inflation. When last deployed, swap lines added nearly $600 billion to the Fed’s balance sheet. A comparably large expansion this time can’t be ruled out. That puts more dollars into circulation, risking price pressure. The Fed could avoid this by selling some of the $1.7 trillion of bonds it has bought over the past year, but hasn’t committed to do that.

Another worry is moral hazard. If governments and central banks repeatedly step in to provide liquidity to interbank funding markets, it increases the risk that banks make dodgy bets — relying on the authorities to backstop them. That could increase systemic risk.

Critics of the Fed in Congress don’t like the way it has used its powers to lend to banks and open swap lines, saying such moves ought to require legislative approval.

Arresting contagion is a laudable goal, but interventionist actions have a tendency to hide underlying fiscal and monetary problems.

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