Central banks open up spigots in bid to ease fears

By Joellen Perry and Alistair MacDonald
The Wall Street Journal
Tuesday, September 16, 2008

http://online.wsj.com/article/SB122146752303935835.html

Central banks around the world pumped cash into money markets Monday as the toppling of Wall Street titans sent shock waves across the globe.

Investors also raised expectations that the world's major central banks would cut their key interest rates soon, as financial-market gyrations force policy makers to focus more on the threat of sharply slowing economic growth than on inflation.

Still, the interest-rate outlook for the U.S. Federal Reserve remains uncertain; officials are inclined to leave interest rates unchanged, but their views could change quickly if markets become highly unsettled. European Central Bank President Jean-Claude Trichet also reiterated policy makers' focus on keeping prices steady.

The ECB pumped an extra E30 billion ($42.7 billion) in one-day funds into euro-zone money markets to halt a steep rise in the interest rates banks charge one another for overnight loans. Facing similar strains, the Bank of England stepped in with L5 billion ($9 billion) in extra three-day funds for British banks. The Swiss National Bank also offered financial institutions extra overnight funds, a spokesman said, but he declined to say how much.

A sharp jump in the federal-funds rate, the overnight lending rate targeted by the Fed, pushed the Federal Reserve Bank of New York to accept $50 billion in overnight repurchase agreements late Monday morning, following a $20 billion transaction earlier in the day.

The moves came as Lehman Brothers Holdings Inc., the U.S.'s fourth-largest investment bank, filed Monday for Chapter 11 bankruptcy protection. Merrill Lynch & Co., a 94-year-old Wall Street institution, sold itself to Bank of America Corp. for $50 billion, and insurer American International Group Inc. cobbled together a survival plan that involved selling off its most valuable assets and going to the Fed for help.

The heads of the world's top central banks decided Sunday that if Lehman filed for bankruptcy protection, each central bank would move to calm its respective market, according to a person familiar with the matter. Calls between policy makers throughout the day Sunday followed a Saturday conference call between central-bank heads from the Group of Seven leading economies, according to another person familiar with the matter.

In a surprise move that underscored fears about U.S. financial-system strains spreading through the global economy, China's central bank cut its key rate for the first time in more than six years. Lowering the benchmark one-year lending rate by 0.27 percentage point to 7.2% was meant to "maintain the steady and fast growth of the national economy," the central bank said. The Reserve Bank of Australia injected an extra 2.1 billion Australian dollars (US$1.7 billion) into its money markets.

With European money markets still off-kilter, analysts expect European central banks to pump in more extra cash this week. Despite Monday's extra cash, euro-zone overnight interest rates hovered around 4.37%, well above the ECB's policy rate of 4.25%.

The turmoil also pushed markets to bet that U.S. and European central bankers will cut their key interest rates sooner than previously expected. European interest-rate futures indicated investors see the Fed cutting its key rate by a quarter-point to 1.75% Tuesday, though it is far from clear that the Fed is prepared to act again. Futures pointed to the ECB lowering its policy rate by a quarter-point to 4% by March and Bank of England policy makers lowering their key rate to 4.75% next month, from 5% now.

While the Fed has cut its short-term rate target to 2% from 5.25% a year ago, European monetary policy makers have focused on inflation and spurned aggressive rate cuts. Euro-zone inflation in August was 3.8%, well above the ECB's preferred zone of just below 2%. U.K. inflation in July was 4.4%, more than double the Bank of England's target.

The current upheaval could change that calculus.

"The question is: At what point does their focus shift from the ghastly outcome of rising inflation expectations to the ghastly outcome of an economy unraveling in the midst of a major credit crunch?" said David Mackie, an economist with J.P. Morgan Chase in London, noting that continuing credit-market turmoil or stock-market slides could usher in rate cuts sooner than markets expect. "I think we're getting closer."

* * *

GATA is a civil rights and educational organization based in the United States and tax-exempt under the U.S. Internal Revenue Code. Its e-mail dispatches are free, and you can subscribe at http://www.gata.org/.