Central banks agree on cash, at odds over rates

FRANKFURT/WASHINGTON (Reuters) - One year after the credit crunch hit, major central banks are pulling together to buoy global liquidity supplies but are poles apart on interest rates.

While the U.S. Federal Reserve has slashed rates aggressively to blunt the economic impact of market turmoil and dismal property markets, the European Central Bank raised rates last month to a near seven-year high with inflation at a record.

British inflation is also surging but the Bank of England is sitting tight for now. It has cut rates three times since last August, when U.S. subprime mortgage defaults spilled over to infect global financial markets, but by far less than the Fed.

The disconnect on monetary policy contrasts with rapidly dovetailing approaches to lubricating money markets with extra cash, at least between the ECB and the Fed, which has overhauled its liquidity operations over the last 12 months.

Economists said the ECB set the standard in the first wave of massive central bank liquidity injections to keep funds circulating in the global financial system after jittery banks shut down wholesale lending between each other.

But they praised the Fed for catching up quickly and for also cutting rates, while noting that the ECB and the BoE are officially bound to focus more on inflation than the Fed and face differing economic conditions.

The Bank of England's initial reluctance to get involved in the market turmoil cost it credibility at the start of the crisis, analysts said, but it had since thawed.

"They have all done a pretty good job," Goldman Sachs chief European economist Erik Nielsen said.

"The ECB had a better set-up than the others, the Bank of England took a little bit longer to get its head around things and appreciate the risk, but the Fed seemed to learn quite fast."

LIQUIDITY FLOOD

The ECB won plaudits for being the first central bank to react to growing unease on financial markets about U.S mortgage defaults, lending out a record 95 billion euros in overnight funds on August 9 last year to keep money markets afloat.

The Fed -- along with other global central banks -- followed suit but was hampered by having a less flexible framework for market operations than the ECB.

The Fed's launch of its Primary Dealer Credit Facility, which offers discount-rate lending to investment banks and securities firms, and its Term Auction Facility cash offerings for banks, which have reduced the stigma of vulnerability attached to direct borrowing from the discount window, have mirrored ECB liquidity facilities.

A year on, the ECB is still providing extra funds at its regular weekly money market operations and has introduced six-month loans and more frequent three-month operations.

As well as providing extra funds to banks in their own jurisdictions, the Fed, the ECB and the Swiss National Bank have joined forces to boost global dollar funding, a program which was extended for the third time last week.

Bruce Kasman, head of economic research for JP Morgan, said the Fed had to play catch-up to the ECB in part because the euro zone does not have U.S.-style stand-alone broker dealers.

"They've both been operating pretty aggressively on the liquidity side," he said. "The ECB and the Fed have moved to a more similar framework here, with the Fed having to do more of the motion."

At the same time, the ECB may be courting trouble with its willingness to accept a wider range of securities as collateral than the U.S. central bank, analysts said. (For story, please see ID:nL8563846)

"I'm not convinced it would have been appropriate for the Fed to accept whatever came its way as collateral during the worst of times," said Douglas Porter, an economist with BMO Capital Markets in Toronto. "The Fed could have been stuck with a lot of low quality securities at not-appropriate discounts."

The BoE, for its part, has not taken part in the joint liquidity action but has extended extra funds to British banks and created an open-ended scheme to get markets moving by accepting mortgage securities as collateral.

Like the Fed, it has had to cope with a threatened bank collapse, Northern Rock in Britain and Bear Stearns in the U.S. -- a complication that has bypassed the ECB, which has no direct role in bank oversight or as the lender of last resort.

RATES MISTAKE?

Over the last year, the ECB has been at pains to separate its liquidity injections from its monetary policy, in contrast to the Fed.

The different approaches have meant that while U.S. rates have fallen by 3.25 percentage points to 2 percent, euro-zone borrowing costs rose a quarter point to 4.25 percent in July.

Although most economists have sympathy for the ECB, which is facing inflation of more than double its 2 percent ceiling, some say its approach is less suited to coping with the second phase of the credit crunch, where financial stress is chronic rather than acute and is dragging on the economy.

"At the early stage of the crisis I would have told you that the ECB was a shining example of good management but now I am less sure," UniCredit global chief economist Marco Annunziata said. "We are seeing now in the data a very sharp deterioration of growth in the euro zone -- the decision to hike rates may have been a mistake."