Friday, December 23, 2011

Will the ECB's 'fine tuning' Avert a Crisis?

The European Central Bank (ECB) just offered their first of two "fine tuning operations."  These seem like the opposite of fine tuning, because the first is one of the largest loan operations in ECB history.  They loaned 640 billion euros to banks at 1% for three years.  The second fine tuning operation will take place March 22, 2012.

Mario Draghi (photo: Daniel Fallenstein)

This comes after ECB President Mario Draghi had announced that he wouldn't be purchasing sovereign debt to hold down the interest rates.  The ECB was criticized for this stance, and comparisons to Nero playing his fiddle while Rome burned were made.  Part of this might be a misunderstanding.  One important thing to note is that the ECB does not work exactly like the Fed.

When the Fed wants to increase the money supply, they enter into repurchase agreements with banks involving short term Treasury securities.  When they want to make longer term monetary policy decisions, they purchase the securities or bonds outright.  So, the Fed doesn't buy U.S. debt directly from the U.S. government but it allows for them to have influence over the U.S. bond interest rate and prices in addition to providing liquidity to the banks and the economy at large which is the ultimate goal.

The ECB operates slightly differently.  When they want to make monetary policy decisions, they loan directly to one of their member banks.  That loan might be short or longer term, depending on the policy goals.  So their influence on sovereign debt interest rates is much more indirect.

This action by the ECB is the first credible step that they have made to stabilize this crisis.  For one thing it directly injects much needed liquidity into the economy.  If banks purchase sovereign debt, it could push down yields and provide much needed breathing room for Greece, Italy, Portugal, Spain, etc.  Of course, they don't have to... and in the days following these loans, the yields for Italian bonds which have really become the weather vane for Europe, have not gone down.

This might mean that one of the key differences between the ECB and the Fed, might be a critical problem for Eurozone countries suffering through this debt crisis.  This "fine tuning" is a positive first step towards stabilizing the Eurozone, but if interest rates do not fall, the ECB should consider modifying their loan program in March towards a more Fed-like system.

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