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Monetary and capital markets

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Central banks faced with a dilemma

Thu, Nov 22 2007, 15:25 GMT
by La Caixa Economic Research Dept.

La Caixa

On October 9, the Federal Reserve (the Fed) published the minutes of the meeting held on September 18 when it took the decision to lower the reference rate from 5.25% to 4.75%. The minutes reflect that a good part of the meeting was devoted to discussing the effect of the sub-prime mortgage crisis on growth. The members of the Fed reached two important conclusions: 1) inflationary pressures in the United States had moderated and did not represent any problem over the medium term and 2) the risk to the growth scenario had increased and had moved to the central point of the economic monitoring radar of the US central bankers.

 On the other hand, following the meeting on October 4, the governor of the European Central Bank (ECB) read his usual comments putting the accent on inflationary risks. For the ECB this was a major dilemma. On the one hand, due to the crisis of liquidity in the interbank market brought about by the sub-prime mortgage crisis in the United States, it should avoid raising interest rates in order not to make it worse. On the other hand, it had to keep inflation expectations of the economic agents secure. In order to meet this double challenge, the Governing Council took two important decisions. First, not to raise interest rates until it had more economic information giving it a clearer idea of the impact of the financial crisis. The second decision was to warn that inflationary risks had increased over the medium term and to remind people that the main objective of the ECB was price stability. In the end, the ECB is maintaining a delicate balance. It must avoid any increase in the risk premiums for future inflation while at the same time baling out, that is to say, injecting the necessary liquidity to stop the ship from capsizing.

 Nevertheless, at mid-month a split could be observed among ECB members on the question of inflation. Jean-Claude Trichet, the governor, Axel Weber, chairman of the Bundesbank and Klaus Liebscher, governor of the Central Bank of Austria emphasized the risk of inflation. In turn, the governors of the central banks of Belgium and the Netherlands, Guy Queden and Nout Wellink, respectively, put the accent on concern about growth in the Euro Area.

For the moment, it would seem that the statements by the ECB had their effect although only partly so. The table shows how the 3-month Euribor rate has dropped from 4.79% to 4.63%. Other short-term interest rates in Japan, Switzerland and United Kingdom also went down. But the decreases in the government bond interest rate in these countries hides a situation of flight to quality. International investors have reduced their positions in high-risk assets and have taken refuge in shortterm government bonds with AAA rating, that is to say, free of credit risk. This may be seen clearly in the accompanying graph where it shows the differential in interest rates for interbank deposits and 3-month Treasury bills in the United States and the Euro Area.

Banks lend money among themselves in the interbank market. Naturally, lending money to another bank involves more risk than lending to the State by buying bonds it issues. It is evident that a country’s government bonds with top credit-rating involve a lower risk seeing that states have the power to make collections through taxes, which private companies do not have. For this reason, in order to compensate the higher risk they demand a higher return. Under normal conditions in the Euro Area interbank market on the 3-month interest rate banks require a premium of 8 basis points above the yield offered by a Treasury bill (100 basis points equal 1%). In the United States, the differential is approximately 20 basis points, that is 0.2%. On the other hand, in order to obtain funds in both interbank markets, the other bank requirement is a differential of 0.7% above 3-month Treasury bills.

The message is very clear. Banks prefer not to lend money in the market unless the price compensates for the risk created by the uncertainty about the subprime mortgage crisis. This situation reflects the lack of confidence currently existing in bank markets. The financial markets have still not normalized their situation although it is true that the interventions by the central banks have so far helped get over what up to now has been the worst moment of this crisis since it broke out at the beginning of summer.

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Published on  Thu, Nov 22 2007, 15:28 GMT