The Fed has shocked us once again, and it’s probably right. There’s a firestorm on the horizon. It starts in Europe, but it threatens the U.S. economy just as surely, and the Fed is getting ready.The most fundamental role of any central bank is to deal with a financial market crisis, to ensure markets operate as normally as circumstances permit. A central bank does this primarily by ensuring an adequate flow of liquidity to market participants, whether banks, other financial institutions, or other central banks. It is in this light one should view the coordinated announcement by the Federal Reserve along with the European Central Bank and four other central banks across Europe and Asia.Specifically, the Fed cut the price of emergency dollar funding from 1 percent to a half a percent. The Fed has arrangements with other central banks that allow it to swap dollars for other currencies on an overnight basis. The Fed cut the price of these swapline arrangements and extended the life of the swapline by 6 months to February 1, 2013.As the global reserve currency, much of the world’s commerce takes place in dollars. Foreign central banks often source dollars to their own banking systems, which use the dollars to fund internal commerce as well as export purchases. Inadequate dollar liquidity abroad can upend financial markets abroad and also in the United States. Three years ago, these same financial markets hemorrhaged during a financial crisis, and the U.S. unemployment rate is still around 9 percent.To be clear, the Fed is not bailing out Europe or the euro. There has been some musing about the Fed bailing out the euro—an idea so preposterous it doesn’t rise past the level of cocktail party speculation. But what the Fed is doing is something quite different. It’s not putting taxpayer money at risk. It’s not buying foreign sovereign debt. It’s not increasing the bailout capacity of the International Monetary Fund or any of the tools Europe has constructed to paper over its troubles. The Fed is just beefing up its own tools for lending dollars on a short-term basis to foreign central banks.Why now? Europe, of course, is going through a terrible time financially and economically, but where’s the crisis that would trigger such an action by the Fed? And why is the market reacting so positively? Just wait.A good way to think about this is to imagine that every fire engine in and around New York City were to converge on Manhattan. Every fire truck would lay out every bit of hose and tap every fire hydrant they could find. Every post is manned and ready, but there’s no fire, only a little smoke. Just wait.The market’s reaction is analogous to a real estate buyer who sees all this fire equipment, decides the neighborhood must be really safe, and bids up the nearest townhouse. Today’s 400-point initial rally in the Dow is proof positive that markets are either irrational, perfectly myopic, or both.What’s going on here? The Fed and its counterparts in Europe and Asia are getting ready for utter calamity. The crisis in Europe is reaching a crescendo. Bank credit in Europe is collapsing; interest rates, even in Germany, are rising; recession and worse is at the doorstep in southern Europe and threatens to engulf the entire continent; even the euro technocrats are now talking about having only a matter of days to save themselves and their beloved monetary union.There’s no real fire yet. But there will be. A big one. It’s heading this way, and the Fed is doing what it can to get ready.
The Fed, Other Central Banks Prepare for the Firestorm