The charge of the central banks

Yesterday marks a turning point in the story of the credit squeeze. The world’s major central banks have united – the Federal Reserve providing dollars to the European Central Bank; the Bank of England abandoning its hardline stance – to take unconventional action in the money markets. The battle may not yet be won, but the cavalry has arrived.

When financial markets break down completely a central bank has no choice but to take their place. The situation is not as extreme as that of Japan in 2001, when the central bank provided almost unlimited sums to the banking system in an effort to increase lending, but it is time to take a step in that direction. The credit squeeze has lasted for four months and shown signs of getting worse. That it will affect the real economy is no longer in doubt.

The Federal Reserve will therefore offer a series of one-month loans, starting with $20bn on Monday, to the bank willing to pay the highest interest rate. It will provide dollars to the ECB so that it can do the same. And the Bank of England will aggressively intervene in the three-month sterling money market.

Like the commanders of a disorderly retreat, central banks have to date staged a piecemeal response to the credit squeeze, to little effect. Their discount windows, which lend to solvent institutions at a penalty rate, have been idle. No bank wants to use them for fear of sending a signal to the market that it, like Northern Rock, is in distress.

The new Fed auctions are a promising attempt to solve that problem. A wide range of institutions will be able to borrow against a wide range of collateral, but more importantly, the minimum rate in the auctions will carry no penalty. The identity of successful bidders will not be disclosed and no one bank will be able to bid for more than 10 per cent of the amount on offer, so there should be no stigma attached to banks that borrow in this way.

It still may not work. Even $20bn injections of liquidity will not finance much of the US banking system’s $10,800bn in assets. Nor will they persuade the markets to lend to banks where solvency or credit quality is in doubt. But once begun, and if they feel the risk to public funds is justified, central banks can expand their operations until they bring market interest rates down to normal levels.

Rather than the immediate effects, what matters about Wednesday’s action is that the world’s central banks have recognised the problem, united and taken action. They cannot magically erase a decade of excess from the credit markets. But their resolve alone will do much to restore confidence.