A quiet revolution in central banking is gathering speed, as the Federal Reserve ploughs ever deeper into the brave new world of unorthodox monetary policy and other central banks ponder how far they might have to follow.


The world’s central banks have already undergone dramatic changes since the start of the credit crisis more than a year ago. They have cut interest rates with unprecedented rapidity – in some cases to historic lows – and have increased bank reserves massively to meet heightened private sector demand for liquidity.

They have become de facto central counterparties in the money markets, and in some cases even direct lenders to companies. Moreover, by making liquidity available against collateral on terms far more favourable than those that prevail in the private markets, they have become in effect catastrophic risk insurers of last resort for whole classes of financial assets – taking on the risk that the crisis could become so bad that they cannot recoup their loans.

But the latest steps by the Federal Reserve – which cut interest rates virtually to zero last week and said it would create money to finance ever-larger credit operations – break new ground.

Already the Fed arguably has one companion, the Bank of Japan. The BoJ cut rates to nearly zero on Friday, stepped up its purchases of government bonds and said it would buy commercial paper.

When central banks want to stimulate a slowing economy they normally cut interest rates. But when rates approach zero other tactics must be employed.

Like the Fed, the BoJ is likely to end up funding these purchases by expanding its holdings of bank reserves and therefore the narrowest measure of the money supply. Unlike the Fed, it has the option of issuing its own debt instead.

The Bank of England, while cautioning against assuming that it will follow the Fed into unorthodox territory, is thinking about what it might do in certain circumstances if UK interest rates also fell towards zero.

The European Central Bank as a whole is much less prepared to countenance the possibility that eurozone interest rates might end up so low. However, ECB officials say this does not rule out some forms of innovative operations.

That these issues are even being discussed in so many big economies is truly remarkable. Radical as the measures taken by central banks collectively to date are, the territory that lies beyond zero rates is still more unfamiliar.

Only Japan has any experience of unorthodox monetary policy. At the turn of this decade it adopted a strategy of quantitative easing – increasing the money supply by increasing bank reserves – in the hope that this would end deflation and boost lending.

The strategies under consideration today bear some resemblance to Japan’s quantitative easing, since they involve swelling the central bank’s balance sheet by more than the amount required to accommodate an increase in the private sector’s demand for liquidity.

Richard Berner, chief US economist at Morgan Stanley, says the Fed’s strategy amounts to “targeted QE”. But senior Fed officials do not think quantitative easing was a big success in Japan. The Fed says its own strategy is to stimulate the economy by driving down actual borrowing rates – increasing reserves only as a by-product– and it prefers to call this credit policy or credit-based easing.

Even the BoJ does not think quantitative easing was an enormous success, and denies that what it is doing now amounts to the same thing.

The ECB remains distinctly wary about further cuts in official borrowing costs, now at 2.5 per cent, with some officials concerned about running out of ammunition – a concern that runs directly contrary to Fed thinking – or of sowing the seeds of the next bubble.

However, the ECB could still follow the Fed into the realms of unconventional policy actions if necessary. Jean-Claude Trichet, president of the ECB, told the FT the ECB’s balance sheet had increased by an “impressive” 55 per cent compared with a year ago.

He did not rule out the possibility of the ECB buying government debt at some stage, even though such an option was not currently being considered.

The Bank of England, for its part, stresses that it is still in the realm of conventional policy, with rates at 2 per cent and no difficulty holding them there. It has nearly doubled the amount of reserves to L44.6bn over the past year, in line with its convention that banks can demand whatever reserve levels they choose once a month.

But the Bank is making contingency plans for what would happen if rates had to go close to zero. Charles Bean, the deputy governor, told the FT such policies might have to be considered before rates reach zero and banks have little incentive to manage liquidity. The “essential purpose”, he said, would be to drive borrowing rates lower, and stimulate spending – the same logic that drives the Fed approach.

http://ft.onet.pl/0%2C18977%2Ccentral_banks_revolution_gathers_pace%2Cartykul_ft.html

If spending needs to be stimulated the Fed only needs to take over the major chain stores and reduce the prices as low as they've reduced the interest rates.

To be honest I'm dumbfounded that anyone in the current economy would get into a debt as large or larger than a modest home mortgage. How anyone could imagine they are secure enough in their jobs to get into greater debt, no matter the interest rate, is beyond me. Yet I have friends who seem oblivious, and make plans to buy thier new $30,000 car or their first home.

Maybe I'm an alarmest, or maybe I'm feeling guilty, because I hope the economy fails. I hope the Fed and all central world banks are doomed. In these hopes is the betrayal of those friendships, how can I wish them the greatest success and joy when my mind is divided between that wish and the hope that economic disaster will bring about a new civil order?

In the end,we will all either continue to be slaves to monetary powers or we will suffer in other ways. We know how life is under the regime of the money machine. I'd like to think we could try something new, make it better.

I'm glad I'm not the only one who is feeling this way. I know it will be horrible, but I think maybe we have to go through this to figure out a better way. Because they will never make the really serious changes needed unless they really fail.

Moondark, so glad to hear another voice in chorus.

I hope you guys are right because it scares the crap out of me.

I have to admit I am not completely sure what you said, but if by fail you mean that people should relearn how to be more careful with money and not spend what they don't have. I agree! And I can't imagine anyone thinking about going into debt any time soon, unless they know a heck of a lot more than I do about money.

I am no wizard when it comes to money, I just know that if want something, I can't have it until I can pay for it. I find that useful for a couple of reasons. One is that, buy the time I can afford to buy it I generally do not want it anymore. Saves me from buying things I mostly never needed, and I have money for something that was absolutely needed that I didn't expect, like the dentist or whatever.