A small but important contribution to solve the financial crisis
ECB policy rates are now at 3.75%, and it was not even the most important decision the ECB took yesterday. That was to make unlimited funds available to the banking system at the new repo rate. In terms of liquidity policy, this is the nuclear option. The ECB is now providing banks with unlimited funds of 3.75%.
This has a number of implications. The first is that illiquidity can no longer be a reason for a bank to get into difficulty. Whatever problems we are seeing now, they will be do to insolvency. Second, as banks get unlimited fund at the best possible rates from the ECB, there will be correspondingly less demand for money market funds. Of course, a functioning money markets is a much more flexible way for a bank to obtain cash, for example cheap overnight cash. So the situation is not ideal. But it is working.
Yesterday, equity markets reacted cautiously to the interest rates cuts because monetary policy is not going to be the solution to this crisis. The ECB is close to the end of its rope. Maybe there will be another accumulated 50bp cuts before the end of the year, but this is about it The solution to this crisis will have to come from governments. The two most promising strands were government recapitalisation of the banking sector through preference shares, and a temporary public sector insurance for the inter-banking market. Britain, not the euro area, has been a leading proponent of both ideas. This is where the political action will be, as G7 and IMF meeting over the weekend in Washington.
Meanwhile, the ECB did the right thing in our view. The latest escalation of the financial crisis has reduced growth forecasts, and reduced inflation forecasts. We still do not see any danger of a significant undershooting of the ECB’s inflation target, except during a global depression, and would advocate – and expect – a cautious interest rate cutting cycle. But the situation is markedly different from June/July, when the ECB raised interest rates. The repo is a policy instrument, not a belief system. It is meant to cut be raised and cut according to the best information available. The case for a rate increase in June was as overwhelming as the case for a rate cut was this week.