A Flood of Liquidity & the Surge in Inflation
By Adrian Ash
November 30, 2007
A flood of money is trying to wash away the mess
in world credit markets. What will it do to your cost of living...?
"THE ECONOMY has been hit by two shocks," announced
Andrew Sentance, a member of the Bank of England's policy team, in a speech on
Tuesday night.
Sentance was talking about the British economy, but his point was
more general. These two shocks – both with "HATE" tattooed on their
knuckles – have smacked policy-wonks square in the face right across the
developed world.
What shocks exactly? "Financial market turbulence and a sharp
rise in oil and some other commodity prices. [They] are operating in opposing
directions in terms of their impact on inflation," says the Bank of
England's man.
"So judging the appropriate monetary policy response will not
be easy."
But who needs to both judging the appropriate response when he's
got a printing press and an unlimited line of credit from tax-payers?
Forget about the Bank of England lending £25 billion – more than
$50bn – to prop up Northern Rock, however.
Yes, that over-geared mortgage lender would have folded by now in a
less "responsive" political environment. But NRK is just one credit
institution begging money from the Western world's central bankers right.
Growth in the European money supply, for example, just hit a
28-year record in October, the European Central Bank reported on Wednesday.
The broad M3 money supply – "which the ECB uses as a gauge
of future inflation," as Bloomberg notes – rose 12.3% from Oct. last
year, the fastest rate of growth since July 1979. And this monetary inflation
will only rise faster when November's numbers come out late in Dec.
Last week alone, the European Central Bank promised to supply the
money markets with an extra €30 billion ($44.27bn) in short-term funds,
"another indication that the credit crisis is far from over," as Sean
O'Grady reports for The Independent in London,
So far, however, no cigar. On Wednesday this week, the ECB made its
biggest loan of three-month money since April 2001, as the global credit crunch
pushed the interbank lending rate up to 4.743%.
The ECB's current target rate for Eurozone interest rates is 4.0%,
and these short-term loans are designed to help ease upward pressure on the
free-market rate by making easy with central-bank cash.
But even after Wednesday's record auction of €50 billion
($73.7bn) "we didn't see any effect on markets," one money-market
trader told Reuters.
"The amount [that private banks] need is a lot more than the
ECB is allotting."
Resolving tensions in the financial markets, of course, is only
one-half of a central banker's task, however. His other key responsibility –
and central bankers are almost without fail always male, if not men – is
defending "price stability". In other words, inflation must not be
allowed to rise above some target or other, decided over tea and biscuits in
hushed conference suites after heavy meals under dull skies.
The inflation target is currently set at 2% in both Europe and the
United Kingdom. On Tuesday this week, however, the Federal Statistics Office of
Germany announced that consumer-price inflation in the world's third-largest
economy will rise by 3.0% in Nov. – the highest rate of price increases since
Feb. 1994.
"A sense of impending inflation is currently influencing
German consumers," warns the highly-regarded GfK consultancy. "The
positive factors currently evident, such as the sustained improvement on the job
market and rising incomes, seem unable to prevent the evaporation of
optimism."
"Solid anchoring of inflation expectations is all the more
important in a period of turbulences associated with this market
correction," as Jean-Claude Trichet, president of the European Central
Bank, said in a speech on Monday this week.
Trichet's comment neatly sums up the head-scratcher now costing
central bankers their hair the world over. You either bail out the money markets
with a flood of liquidity...or you keep a lid on inflation.
You can't do both, not according to history. And every so often –
not least when you're bruised and beaten by a fearful credit crunch on one side
and a hateful oil-price shock on the other – it seems you can't achieve
either.
Just ask Andrew Sentance at the Bank of England. In Tuesday night's
speech, he 'fessed up to an inflationary mess that looks a little like this...
The US Federal Reserve, meantime, is also presumed to be targeting
2% annual growth in its Consumer Prices.
And just like the ECB, it's also pumping money into the New York
credit market at a record clip.
But if the ECB can't keep a lid on inflation nor end the credit
crunch, can the US central bank really have it both ways?
The US Fed is forever making short-term loans to the money markets.
Adding what's known as "liquidity" is nothing unusual for the world's
biggest central bank, just like it's nothing unusual for a pub landlord to serve
beer.
The Fed offers money to the big New York banks in exchange for
good-quality securities – securities such as, say, US Treasury bonds or
government agency debt. And it will lend money for anything between 24 hours and
two weeks or more.
On any one day, you might find the New York Fed making two, three
or more of these loans via auction. And between the start of 2001 and the end of
last month, the average sum lent in each of these auctions was $6.01 billion.
Since the start of this month, in contrast, each of the Fed's
short-term liquidity auctions has averaged $10.17 billion.
The quality of the collateral that the Fed accepts when making
these loans has changed dramatically, too.
The Fed has always been happy to accept mortgage-backed bonds as
security for the short-term cash injections it makes. If the New York interbank
lending rate needs a little shot in the arm to cool it down, AAA-rated
mortgage-backed securities are just fine.
But as you can see, the big banks stepping up to the Fed's auctions
have always been keen to use more mortgage-backed securities (MBS) as collateral
than the Fed would accept.
Indeed, the ratio of MBS submitted to MBS accepted averaged only
0.55 between Nov. 2000 and the end of July '07. More times than not, the Fed
said "no" to home-loan backed bonds. It demanded US Treasury notes or
agency debt as security for lending hard cash instead.
But since the credit crunch first bit at the start of August, the
New York Fed has relented somewhat. The ratio of MBS submitted to MBS accepted
when bidding for the Fed's cash has risen to 0.85.
And while the size of the Fed's injections – as well as the
volume of mortgage-backed bonds held against them – have both grown
substantially, the frequency of those injections has also soared. There were 29
temporary Fed injections in the first 28 days of November alone.
Over the preceding seven years, the New York Fed averaged fewer
than 25 injections per calendar month.
It's not only the Fed that's supporting the local housing market by
accepting mortgage-backed bonds as collateral for new loans. Last week,
Australia's central bank lent A$500 million – some US$435m – in a series of
re-purchase agreements based on mortgage-backed bonds. On Thursday alone it
bought A$100 million of home-loan debt, set to mature in just over three months.
"This is the first high-volume activity ever in this market
and may encourage further investor participation," reckons Warren Mellor,
an analyst at National Australia Bank in Sydney, talking to Bloomberg. It might
just encourage Australia's financial firms to park as much of their home-loan
inventory at the Reserve Bank, too.
Sales of Australian mortgage-backed bonds sank by 94% between July
and Sept., the newswire adds, down to a meager A$1.8 billion – a five-year
low.
Can the Reserve Bank reverse this slump? It claims to love
mortgage-backed bonds so much right now, it's willing to lend hard cash against
them at a bargain rate of interest.
Sydney's interbank lending rate for 3-month loans reached 7.24% on
Wednesday this week, an 11-year high. The RBA, however, has been happy to lend
for 0.30% below that market rate and more.
In short, the flood of money now trying to wash away the mess in
world credit markets is truly globalized, just like the mess itself.
Does anyone really imagine this will help ease inflation in the
world's cost of living?
What can you, as a private individual, do to defend yourself
against this flood of money forcing your cost of living higher? One proven
response you might consider is to Buy
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