Central banks from the “Group of 10” unveiled a joint plan this week, to pump billions of dollars into the global banking system through a $24 billion currency swap and special lending facilities, aiming to cap the upward pressure on Libor deposit rates, denominated in Euros, sterling, and US dollars. Tensions have been running high in the global money markets since August, since banks are suspected to be saddled with losses of more than half-a-trillion dollars from toxic sub-prime US mortgages. The sub-prime mortgage crisis has nearly shut the commercial paper market, forcing banks to turn to the Libor market for funds. The Fed will set up a new lending facility that will provide up to $80 billion through January. The ECB will offer two US dollar tenders of up to $20 billion in connection with the Fed’s action, and the Bank of England (BoE) will offer bigger amounts of funds and widen collateral options. When market forces go terribly wrong, the free-market champions on Wall Street and elsewhere are not too proud to accept a bailout from the government. Historically, the 3-month Euro Libor rate has closely tracked the ECB’s repo rate, typically pegged at 15 basis points above the repo rate, and then gyrates on expectations of the next move by the ECB on interest rates. But since August, the Euro Libor rate has shot upwards by 80 basis points to +95 bp above the ECB’s repo rate, because banks are more inclined to hoard cash to cover future expected losses from toxic sub-prime US mortgage debt, rather than lend funds to risky borrowers.
So far, the ECB has refused to address the liquidity shortage in the Euro Libor market by easing its monetary policy. Instead, the ECB is holding its repo rate steady at 4% to combat strong inflationary pressures within the local economy. Consumer price inflation in the Euro zone jumped to 3.1% higher in November, far above the ECB’s inflation target of 2 percent. The Euro M3 money supply is expanding at a 12.3% annualized clip, its fastest in history, threatening to stoke faster inflation. On Dec 14th, Slovenia’s central bank chief ECB Marko Kranjec remarked, “There are worrying signs that inflation expectations are becoming dis-anchored. People are starting to grumble, in Slovenia particularly. The chances of a wage-price spiral are much more likely. The strength of the Euro has done some, but only some, of the ECB’s work in tightening financing conditions. In this respect it would be difficult to agree that the market has done the job of the central bank,” Kranjec said. “The current situation is not satisfactory with regards to the inflation rate,” said Belgian central bank chief Guy Quaden on Dec 12th. Quaden said the ECB was determined to prevent higher oil and commodity prices from pushing up wage demands and other goods. “Central bankers, even the best ones, cannot prevent an increase of oil prices or other international commodities. What they have to do is to prevent contagion, the development of so-called second round effects,” Quaden said. Central bankers love to print money, and won’t acknowledge the obvious link between double-digit growth of the global money supply and the upward pressure on crude oil, agricultural and other commodities. The ECB’s Juergen Stark says the ECB now makes a distinction between “first-round” inflation – food and energy, and “second-round” inflation -- higher wages that compensate workers for higher food and energy costs. “That means we will react swiftly if we see that wages are rising too strongly as a result of higher raw materials prices,” Stark said on Nov 24th.
There is good reason to believe that the historic rise in food and energy prices, which are soaring to all-time highs, is not a bubble that will eventually burst, as hoped for by central banks, but instead, is the new reality for years to come. Wheat prices are the stand-out example of “Ag-flation”, more than doubling to record highs this year in the US and Europe with crop pressures, robust exports, red-hot emerging market demand and the bio-fuels revolution serving as major drivers. Soybeans rose to $11.50 per bushel, up 54% to the highest since July 1973, and corn climbed to $4.50/bushel, a shade below a 10-year high, while the Baltic Dry Index, which measures the cost of transporting dry goods across the seas, is up 150% this year. The United Nations said the global cost of importing foodstuffs could top $700 billion in 2007, up 21% from a year ago, and the highest on record. The US government’s top energy forecaster said on Dec 11th that global oil demand will increase by 1.4 million bpd to 87.2 million bpd, “growing much faster than the world’s major oil producers are able, or willing, to boost their petroleum output. Tight market conditions will persist into 2008, keeping oil prices high,” the EIA said. To the ECB’s credit however, by refusing to lower its repo rate, it has covertly engineered a quasi-tightening that’s guided the 3-month Euro Libor rate to 4.95% this week, its highest in seven years. The ECB has also permitted the Euro to climb to as high as $1.50 before it began to protest loudly to currency traders that the Euro rally had gone far enough. Both measures -- the spike in Euro Libor rates and the strong Euro can slow the economy and help to ward off commodity inflation. Gary Dorsch © 2007 Gary Dorsch
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