The Hindu Business Line : Central banking in a crisis

As the inter-bank money market evaporated, the ECB was quick to inject all the liquidity that was needed for payments and settlements. The US Fed too lost no time in keeping the market supplied with ample funds.

S. Balakrishnan

If there is a financial earthquake, conventional wisdom, must be thrown to the winds. The recent market upheavals were one such time and opportunity. Fortunately, central banks, the world over, came out of the test with flying colours.

How did they react to the recent turmoil in global markets, which threatened to grow into a systemic crisis?

Did they turn a blind eye to the happenings around them and continue to speak of inflation risk?

Hardly. They could barely afford to. If they had passively watched markets crashing, their credibility would have gone for good.

Public outrage at ‘Nero fiddling while Rome burned’ would have been followed by demands to restrict their autonomy and empower governments to direct them. In the moment of truth, they proved worthy of the trust reposed in them and managed to keep the flag of central bank autonomy afloat.

Injecting liquidity

Good sense prevailed even in that most hawkish of institutions, the European Central Bank (ECB). As the inter-bank money market evaporated before its eyes, it was quick to inject all the liquidity that was needed for payments and settlements. It would be absurd to worry about the inflationary effects when the roof is about to fall on your head.

The US Fed too lost no time in keeping the market supplied with ample funds. Only a couple of weeks back, after its last meeting, it had reiterated its determination not to cut interest rates and expressed its firm view that inflation still posed a danger. It was forced to eat its words.

Events forced the Fed’s hand. It backtracked as soon as it realised the dimensions of the crisis and cut the discount rate (equivalent to the RBI’s repo rate) — the rate at which it lends to banks.

Fed measures

The Fed did not stop with that. Collateral standards for borrowing from its discount

window were drastically watered down. Institutions are allowed to use non-treasury collateral to borrow from the Fed — in fact, any ‘investment’ grade asset will do.

It is also willing to lend treasury securities at cut prices to use as collateral for market borrowing. With all this, who needs a real rate cut, the market must wonder.

Extraordinary situations call for extraordinary responses and remedies. They may not explicitly say so, but central banks ‘closet believe’ a market crisis can infect the economy. (The Fed admitted as much in its statement accompanying the discount rate cut, hinting at an early benchmark rate cut as well).

Monetarism and inflation ‘obsession’ are nice subject matter for high theory and seminars. The real world is far removed.

As one unkind commentator observed, it is the difference between being ‘book smart’ and ‘street smart’.

Related Stories:
Learnings from the financial crisis
Global financial crisis: ‘A lot more is yet to come’
Pains from the sub-prime fiasco
Has Fed discounted the financial market crisis?

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