Monday, August 13, 2007

[Latest Global Dollar Liquidity Measure: +15.1% annual growth rate; latest Endogenous Liquidity Index: -28.1%]

Back from a short summer break, I see a lot of confusion among journalists (and even among some market strategists) with regard to central banks' liquidity injections. Decades ago, central banks abandoned their money supply targets in favor of short-term interest rate targets. This is the key to understand what is happening right now. Central banks are simply ... playing by the rules! If, for wathever reason, short-rates deviate significantly from their targets, central banks have the duty to step in. (Yes, Virginia: the duty).

They will add liquidity if market rates increase above the target (which is what they are doing); they will withdraw liquidity if rates go down below the target. It is largely a mechanical operation. No politics, no moral hazard considerations involved! Admittedly, it does not happen often. But when it happens, either you apply the rules, or the system breaks down altogheter. Take a look at the Fed August 10 communiqué:

The Federal Reserve will provide reserves as necessary through open market operations to promote trading in the federal funds market at rates close to the Federal Open Market Committee's target rate of 5-1/4 percent. In current circumstances, depository institutions may experience unusual funding needs because of dislocations in money and credit markets. As always, the discount window is available as a source of funding.

This is a cristal-clear explanation of a fairly mechanical point. Again: no discretionary moves, no politics, no conspiracy theories, no moral hazard issues. Just a bunch of people playing by the rules. I'm lovin'it!


Zach said...

Aside from moral hazard, does this present a problem as far as allowing market dislocations which awakened this lack of liquidity to be postponed, but still a problem when the banks who have borrowed this liquidity from the fed are required to repay? Do you anticipate a rash of banks entering stages of default as these short term loans become due?


Agustin said...

Zach, other than a careful analysis of market-based indicators, I have no specific info about default probabilities at banks. I am currently paying a lot of attention to the Moody´s Baa spread, because it has provided a very decent indicator (together with the rate of growth of funding liquidity) in terms of big, long-term turning points. Still bullish overall, but the test is severe!

jp said...

--If, for wathever reason, short-rates deviate significantly from their targets, central banks have the duty to step in--

What about now that we have the converse, a federal funds rate of 4.75, way below the target of 5.25. Is it not the duty of the fed to step in and sell securities for cash ie engage in reverse repos and bring that thing up? It seems hypocritical that when the ff rate gaps .5% above the target, the fed rushes to the rescue, but not vice versa. By your criterion, a deviation of rates from their target, the fed is not doing its job right now.

Just found your blog recently, looks good!

Deliz said...

Good post.