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.
