Fed to split monetary and liquidity policy

Financial Times:

The Federal Reserve is unlikely to make any big changes to its monetary policy stance at the conclusion of its December meeting on Wednesday, though there is a chance it could make some alterations to its provision of liquidity.

The US central bank is likely to keep the key line of its policy guidance – in which it says it expects to keep rates at “exceptionally low levels” for an “extended period” – unchanged.

However, it is possible that policymakers might announce a decision to increase the discount rate at which the Fed makes emergency loans to banks, perhaps coupled with reaffirmation from the Fed board that it will shut down many emergency liquidity programmes on February 1.

This would at the margin tighten financial conditions slightly, but it should not be mistaken for a tightening of monetary policy.

As the crisis ebbs, the Fed is borrowing a page from the European Central Bank, which draws a sharp distinction between monetary policy and liquidity policy, through a so-called “separation principle”. Senior Fed officials thought this distinction problematic mid-crisis but now believe it has relevance to the exit process. With financial markets once again buoyant but the economy still burdened with high unemployment, normalising monetary policy and liquidity policy can proceed at a differing pace.

The approach of the financial year-end causes the Fed to defer action on liquidity into 2010. This will be the first time the former investment banks and the long-time banks share the same December 31 year-end, making it impossible for them to shift illiquid assets back and forth to show strong year-end positions. Against that, there are more than $1,000bn (€683bn, £614bn) excess reserves in the system to smooth over year-end liquidity stress.

Posted via email from Jim Nichols