We’ve read a lot in recent months about central banks ‘injecting’ money into markets – but how does this work? And how deep are their pockets? Eoin Gleeson explains.
Just how do central banks set interest rates?
Setting interest rates isn’t as simple as just calling a meeting, decreeing the official rate of interest and then watching banks fall into line. What happens (we’ll use the US for convenience) is that the Federal Reserve will set its target rate at, say, 2%, and then – through the Federal Open Market Committee (FOMC) – it buys or sell bonds in the money markets, borrowing or lending to a select number of banks called primary banks – the likes of Goldman Sachs and Bank of America. If the interest rate starts to creep above the target, the Fed buys bonds from these banks, in effect increasing the supply of short-term money in the money market, thus bringing the rate back down again. This system works because each of these banks has an account with the Fed – one of a central bank’s primary functions is to offer short-term loans to banks when they do not have the cash to meet their withdrawals from day to day.
Where does the central bank’s money come from?
America has two printing presses: the Fed and the Treasury. When the Fed injects money into the financial system, via the FOMC, it doesn’t actually print the cash on paper. Instead, it will write a $1m electronic cheque and buy $1m of Treasury bonds from the money markets. The banks that sold the $1m in bonds to the Fed will deposit the cheque in their account at the Fed and then will lend money – maybe ten times the amount of cash in the Fed’s account – on the assumption that the borrowers aren’t all going to demand their money back at the same time. The Treasury prints money by printing bonds and passing them on to the Fed to fund its operations. It also funds the Fed by selling off its Treasury bills to foreign governments. This arrangement has worked quite well over the last decade as the Chinese and Middle Eastern governments have been happy to buy T-bills as fast as the Treasury can print them.
What are the money markets anyway?
This is the global market in which banks borrow and lend to each other over the short term, trading in Treasury bills, commercial paper – short term debt issued by banks – and repurchase agreements. The length of the most-traded loans typically ranges from one day (overnight loans from the central bank) to three months or a year. And the rate at which they are priced is generally benchmarked to the London Interbank Offered Rate (LIBOR), which usually tracks the base rate pretty well – although not at the moment, as we’ll see.
What other kinds of tools do central banks have?
Central banks can also manage the money supply by dictating how much capital banks must keep on their books – the capital reserve requirement. So if the Bank of England is worried that banks are overextending themselves by lending out too much, it can lift the capital reserve requirement so they have less assets to make loans against. But playing around with interest rates and capital reserve requirements has done little to help the Fed and Bank of England during this crisis.
Just now, US LIBOR is sitting some 1.5% above the Fed’s base rate – reflecting the fact that the US money markets are all but frozen at the moment. There are two reasons for this. First, banks have lost trust in each other and are reluctant to offer loans. Second, as Philip Aldrick puts it in The Sunday Telegraph, nobody trusts the value of the dodgy assets (from mortgage-backed assets to collateralised debt obligations) being sold on the money markets. So the Fed has resorted to trying to put out financial fires by setting up quick funding facilities instead. There’s the Term Auction Facility and Primary Dealer Credit Facility, which allow banks to borrow money from the Fed by pledging dodgy assets as collateral. And now we have the Treasury’s $700bn Resolution Trust Corporation, which aims to take the most unwanted subprime debts off Wall Street’s balance sheets. Not to mention the $200bn bailout of Fannie and Freddie and the $85bn the Fed gave to AIG.
Can a central bank run out of money?
Certainly, and the Fed nearly has. It currently has only a limited number of T-bills left to sell, which has been reduced for the moment to $500bn. That means the Treasury has to sell more bonds to foreign investors to raise more money to fund the Fed. So Hank Paulson has to turn to his friends in the East again if he is going to buy up all dodgy mortgage debt festering on Wall Streets balance sheets. But with Americans buying fewer of their goods, how long will the Chinese by happy to pick up the bill for Hank? This bailout is likely to swell the US national debt to $11.3trn and raise long-term interest rates. If it doesn’t work, future taxpayers will pay a very heavy price.
Could the US government default?
The question is how long can the Fed keep bailing out Wall Street? It sounds unbelievable, but the liabilities being taken on by the Fed and US Treasury are now so big the government itself could default, says Liam Halligan in The Daily Telegraph. The market is already pricing in the possibility that the States will struggle to repay some of its long term T-bills. The evidence is in the credit default swap market, which shows that the cost of insuring ten-year US government debt has rocketed in the last month. And as ex-IMF chief economist Ken Rogoff pointed out this week, the $700bn bailout will “open a can of worms” as other distressed US industries, such as automotives, seek a similar rescue. “It is hard to see that this is even half over”.