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Forget the dancefloor Travoltas at your office party. This festive season it’s the worId’s central bankers who stand accused of a grievous loss of self-control. How fair is this? Three categories of central bank action exist. Only the last is of real concern.
First, central banks have now lent enough to ensure that overnight interbank rates are close to policy rates, having been out of sync in September. This is fundamentally desirable – it ensures monetary policy is efficiently transmitted into the market. The European Central Bank has at times withdrawn liquidity to ensure overnight rates are on target.
Second, central banks have acted against the “year-end effect”, whereby banks hoard cash until January. This behaviour is not strictly rational but is understandable and has squeezed up interbank rates, particularly in the eurozone. As during the Y2K scare, central banks have responded. The Fed held a $20bn term auction on Wednesday, the ECB has lengthened its normal financing period and the Bank of England has held a £10bn market operation. Through looser collateral rules and/or cheap pricing, these actions all breach the rules of “prudent” central banking. These counsel against trying to influence the yield curve beyond overnight maturities, which may distort credit risk premiums, and against accepting low-quality collateral, which may transfer risk or losses on to the public. But, given these actions are “one-off”, only purists should worry.
The third category is interventions after the new year, at longer-than-overnight maturities and/or with looser collateral rules. The Fed plans more term auctions and the Bank of England will lend more too. The ECB has no formal plans but has always been more flexible. All three say they just want smooth functioning of money markets but have not defined what this means. There is strong evidence that the high interbank rates they implicitly are trying to lower in part reflect credit risk. Today the governing principle of central banks is pragmatism. In 2008 their decision to use public funds potentially to subsidise risk-taking will face more scrutiny.
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