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Central banks' joint efforts sustain global system

By Martin Crutsinger
AP Economics Writer / March 1, 2012
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WASHINGTON—Never before have the world's central banks sent so much money sloshing through the global financial system.

From slashing interest rates and buying government debt to dangling cheap loans to banks and taking on their risky assets, central banks have taken extraordinary steps since the 2008 financial crisis to nurse the international banking system back to health.

Over the past 3 1/2 years, the central banks of the United States, Britain, Japan and the 17 countries that use the euro have pumped out so much money that their balance sheets have reached a combined $8.76 trillion. That's a record, by far.

The infusion of money has eased borrowing costs and raised confidence in banks, governments and companies.

Critics counter that the flood of cash has made high inflation more likely. And they point to rising prices for oil, food, gold and other commodities as evidence. They warn that the easy money may allow investors to bid stock prices up to dangerous heights.

They also note that the crisis led central banks to accept high-risk investments that banks have wanted to unload. These investments have been collateral for money that central banks gave financial institutions.

Trouble is, the central banks must eventually unload the trillions in assets on their books. That carries risks, too.

A second round of low-cost loans that the European Central Bank gave banks Wednesday is the latest financial injection. The ECB issued $712 billion in loans to 800 banks, on top of $658 billion it lent 523 banks in December.

On Thursday, the head of Germany's central bank, Jens Weidmann, warned the ECB about the risks of loosening rules on collateral for those loans. The more lenient rules mean more banks can borrow.

Weidmann said the policy exposes the ECB and other central banks to more risk, the German newspaper Frankfurter Allgemeine Zeitung reported.

At times, the world's leading bankers have coordinated their actions to maximize the punch. In December, for example, major central banks sought to shore up the global financial system by making it easier for banks to borrow U.S. dollars. It was the most significant joint effort by the central banks since they cut interest rates in October 2008.

The central banks feel compelled to take such far-reaching action because of their role as a nation's lender of last resort. This function is in addition to their core task of managing interest rates and inflation through the money supply.

Each central bank's balance sheet reflects assets it's taken on, such as bonds and mortgage-backed investments. Their balance sheets have soared since the financial crisis exploded.

The Federal Reserve's has reached $2.94 trillion. That's triple its size in August 2008, just before the crisis hit. The ECB's is $3.58 trillion, nearly twice its level before the crisis. The Bank of England's balance sheet has jumped three-fold. The Bank of Japan's is up 28 percent.

"This is the first time in history that we have seen anything like this amount of liquidity from central banks flooding the system," said David Jones, head of DMJ Advisors and the author of several books on the Fed.

Mark Zandi, chief economist at Moody's Analytics, said the only period that even comes close would be the central banks' efforts in the 1930s to fight the Great Depression. But many historians say the Fed prolonged the Depression by failing to provide emergency loans to banks or to take other steps that might have stemmed the damage.

"Ben Bernanke is a historian of the Great Depression," Zandi said of the current Fed chairman. "That is why he has been so aggressive in using the Fed's balance sheet to respond to the current problems."

The central banks have revealed no plans to reverse course and tighten credit soon. The Fed has said it expects to keep short-term rates at record lows near zero until at least late 2014. At a House hearing Wednesday, some lawmakers pressed Bernanke about the risks of keeping rates so low for so long.

"One of the problems with setting these horizons out so far is that the private sector starts to expect that, and if circumstances change, crawling back off that limb could be very difficult," Rep. Melvin Watt., D-N.C., told Bernanke.

"The policy is a conditional policy," Bernanke responded. "It's based on what we know now. If there's a substantial change in the outlook, we'd have to adjust accordingly."

Bernanke hinted that if the U.S. economy continued to improve consistently, the Fed might have to consider raising rates sooner.

For now, following the Fed's lead, other central banks have kept their benchmark short-term rates at super-lows. They've created low-rate lending programs for commercial banks, like the three-year loans the ECB is providing.

And they've bought bonds to try to drive down long-term rates.

The bond purchases are known as "quantitative easing," or QE. The Fed has completed two such programs. Some hope it will announce a third. Supporters note that the U.S. economy remains less than robust, and unemployment is a still-high 8.3 percent. Further reducing rates on mortgages and other loans could energize the U.S. economy, they argue.

Critics counter that more bond purchases by the Fed could ignite inflation. They note that the U.S. economy has been steadily improving, and unemployment has dropped for five straight months. Remarks that Bernanke made at the hearing Wednesday suggesting a brighter economic outlook made further bond-buying appear less likely.

The ECB is legally barred from buying bonds directly from governments. But it's bought 219 billion euros ($268 billion) in bonds on the secondary market to try to lower rates and reduce borrowing costs for Europe's most troubled economies.

The ECB has also been cutting short-term rates and offering super-cheap loans to banks. In its second installment of three-year loans, the ECB is charging just 1 percent interest. The idea is to get banks to use the loans to buy government debt and further ease nations' borrowing costs.

Earlier this month, the Bank of Japan announced an expansion of its own asset-purchase program. So did the Bank of England.

"Everyone is following the Federal Reserve's example of printing money to get out of this economic slump," Jones said.

The Fed's expanding balance sheet reflects its ability to create money, use it to buy Treasurys and lower long-term rates. Lower rates make borrowing cheaper. And they typically cause some investors to shift some money out of bonds and into assets such as stocks. Stock prices tend to rise as a result.

A larger number of dollars in circulation lowers the dollar's value compared with other currencies. That can help the economy by making U.S. exports cheaper overseas.

Central banks face a delicate task in deciding when and how to unload the assets on their swollen balance sheets without jolting the financial system.

Bernanke and other central bank officials have stressed their commitment to gradually tighten credit before inflation poses a major threat.

"Central banks around the world are making a bet that they will be able to handle inflation down the road," said Diane Swonk, chief economist at Mesirow Financial.

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