Why Central Banks Are 'Experimenting'


Caught between a credit crunch and inflation fears, the Fed, the ECB, and others are trying new approaches

When is the last time "central banker" and "creative" appeared in the same sentence? The conservative guardians of the world financial system aren't exactly known as renegades, but the global credit crunch that originated in the U.S. housing market is forcing them to try things they've never tried before.

This week, the central banks of both Europe and the U.S. took a shot at brand new ways to thaw the freeze in lending between banks. The credit freeze threatens to drag down global economic growth, but it's particularly challenging because it's hitting amid rising concerns that inflation is heating up (BusinessWeek.com, 12/4/07). Economists were impressed by the bankers' willingness to innovate. Says economist Kathleen Stephansen of Credit Suisse (CS): "This really gives a very powerful signal to the market. It shows you the central banks understand that there is a liquidity crunch at the turn of the year that they want to deal with."

Bold Move

On Dec. 18, in an operation that was both huge and unprecedented in its design, the European Central Bank made 16-day loans of $500 billion worth of euros to European banks. The significance of 16 days is that it means the banks won't have to borrow again until after Jan. 1. The banks want to be able to show investors and borrowers that they have plenty of funding in place when they close their books Dec. 31.

Ordinarily the ECB auctions off a certain quantity of money, allowing the banks' demand for that sum to determine the interest rate on it. In this case, the bank simply announced the rate (a low 4.21%) and allowed unlimited borrowing at that rate. It was a bold move because central bankers don't like making open-ended offers of money, but the ECB was determined to quell fears of a money squeeze. "This is a substantial injection of liquidity any way you cut it," says Lewis Alexander, chief economist of Citigroup (C).

The move helped boost stock prices (BusinessWeek.com, 12/18/07), with the Dow Jones industrial average picking up 65 points. Among the strongest gainers were Home Depot (HD), American International Group (AIG), General Motors (GM), and ExxonMobil (XOM).

Loan Slowdown

On Dec. 17, the Federal Reserve auctioned off $20 billion in 28-day loans—again, a period long enough to tide banks over into the new year. Although the Fed's lending was much smaller, it was innovative in its own way. The Fed allowed banks of all sizes, not just the big boys, to participate in the auction. And banks were allowed to post a wide variety of collateral, not just Treasuries and high-rated agency securities. The auction, which was announced a week earlier, was intended to restore confidence in the value of banks' assets and thus revive interbank lending.

The central banks' actions seem to be doing their job of avoiding a yearend liquidity squeeze. However, term rates for interbank lending out into the early months of 2008 remain elevated, showing that the bankers still haven't conquered the credit crunch. And banks still aren't making many loans, says Joshua Feinman, chief economist at DWS Scudder, the mutual fund division of Deutsche Bank Asset Management (DB). "Central banks here, quite frankly, are experimenting. They're in a little bit of uncharted territory," says Feinman.

Bert Ely, a banking consultant in Alexandria, Va., who's known for his irreverent declarations, puts it differently: "These guys are flying by the seat of their pants."

Coy is BusinessWeek's Economics editor.

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