Central bank's aggressive move stuns European markets

From Financial Times, London
Tuesday, August 9, 2007

http://www.ft.com/cms/s/569c9418-46a0-11dc-a3be-0000779fd2ac.html

The European Central Bank stunned markets on Thursday with its aggressive intervention to quash a brewing liquidity crisis in European financial markets.

The ECB move far exceeded in scale and scope the relatively modest steps taken by the Federal Reserve to sustain adequate liquidity in US markets.

After noting a sharp rise in overnight interest rates to 4.7 per cent -- far above the target 4 per cent -- the ECB put out a statement in the morning saying it stood "ready to assure orderly conditions in the euro money market."

Within a couple of hours it acted: taking the unprecedented step of offering a pre-announced unlimited tender so that European banks could get as much cash as they wanted.

The last time it stepped in to provide large-scale liquidity in response to market concerns was in the aftermath of the September 11 terrorist attacks. But even then, it did not offer unlimited support.

Equally striking was the amount of money the 49 banks that took up the tender received: E94.8 billion ($129 billion). This was far above the E69 billion banks took on September 12 and the E40 billion the next day. By contrast, the Federal Reserve -- which also saw overnight rates move up to above 5.75 per cent, compared with its target rate of 5.25 per cent -- took less drastic action to support liquidity.

The New York Fed brought forward by a few minutes its normal daily open market operations, injecting a total of $24 billion in overnight and 14-day repos during morning trading.

As of midday in the US, the Fed had not made any public statements.

The scale of US intervention -- about twice the average for a normal day -- is unusual, but does not suggest that the Fed is in full crisis-fighting mode.

It suggests that the Fed believes US markets are still functioning adequately -- albeit in need of some additional liquidity support -- rather than in danger of completely seizing up.

Martin Barnes, editor of the Bank Credit Analyst, an economic newsletter, said, "We have a real role reversal here."

The liquidity shortfall in Europe that caused the ECB to act was grounded in fears about US subprime mortgage securities held by European investors. Moreover, the Fed has traditionally been much quicker to ride to the rescue when markets encounter difficulties, with European central bankers adopting a more hands-off approach, concerned not to cause "moral hazard."

This time, though, the ECB moved to inject unlimited liquidity only two days after the Fed retained its focus on inflation at its August policy meeting.

The stand-out nature of the ECB move was partly driven by the way it interacts with financial markets. Unlike the US Fed, it does not inject or withdraw liquidity every day, but instead conducts what it calls "fine-tuning" every now and then to regulate liquidity -- and such actions were not scheduled for some time.

Many analysts applauded the ECB for its decisive action. Erik Nielsen, an economist at Goldman Sachs, said, "This is outstanding central banking by the ECB and ought to provide a lot of comfort to the market.'

Bruce Kasman, an economist at JPMorgan, said the move sends two signals: first, that the ECB is "ready to provide liquidity to ensure the smooth operation of European money markets," and second, that for now it is happy doing so at its current interest rate.

However, some central bank officials fretted that the ECB move could cause market participants to worry more than they needed to.

"The aggregate liquidity conditions are usual even if there is a bit of turbulence. But there is the risk that banks may not really have needed this amount of liquidity and that the market therefore reads something into this action that they shouldn't do," says one ECB official.

Analysts pondered whether the ECB's step indicated that there were more serious problems in the European financial system that were not yet public.

Meanwhile, the jury is out on whether the Fed is wise to adopt a relatively sanguine approach, keeping its powder dry for use in the event of a true liquidity crisis -- or whether it is dangerously behind the curve and could be soon forced into an embarrassing reversal.

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