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Tags: El-Erian | Central | Bank | dollars | inflation

Experts: Central Bank Move Doesn't Solve Core Problems, May Fuel Inflation

Wednesday, 30 November 2011 12:39 PM EST

Coordinated action from the world's Central Banks to inject liquidity into the European financial system may spark a global stock-market rally, but it won't solve the underlying issues plaguing the European economy such as a political unwillingness to carry out tough reform policies, experts say.

The U.S. Federal Reserve, the European Central Bank and the Central Banks of Canada, Britain, Japan and Switzerland have agreed to lower the cost of existing dollar swap lines by 50 basis points, a half percentage-point cut, a move that makes it easier for banks in Europe to get access to dollars.

The Central Banks say in a joint statement that cutting interest rates on swap lines — short-term loans in this case denominated in dollars — will prevent a credit crunch from striking the global economy.

Banks often borrow from one another in dollars mainly because U.S. interest rates are so low.

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In Europe, where credit is tight due to sovereign default scares, banks need to tap the European Central Bank (ECB) for those dollars, and today's rate cut on the swaps basically makes it cheaper and easier to do so.

"In short, European banks were finding it too expensive to make dollar loans, which hurt their ability to lend dollars and encouraged them to sell euros. This depressed the value of the euro and restricted credit in Europe. The ECB arranged to borrow dollars more cheaply from the Fed, so it could ease this market," CNBC says in an analysis of the deal.

(Getty Images photo)
The move does not represent the U.S. government shipping taxpayer money abroad but rather, makes it easier for banks worldwide to tap and borrow from the pool of dollars flooding the global economy.

A side effect, however, could include inflation.

"The new dollars have the potential to spark inflation—which could result in higher interest rates and higher taxes as the government combats inflation," CNBC adds, pointing out that inflation is not yet a problem in the U.S. as of now.

The move is all well and good, says Mohamed El-Erian, co-head of Pimco, the world's largest bond fund. But it doesn't address fundamental spending and other issues that European governments need to confront, which include pooling bailout money together to prop up weaker economies.

"First, these monetary institutions feel that, again, they have to move because other entities have continued to be too slow and too ineffective; and second, they feel that they cannot, and should not ignore an actual or anticipated need to relieve acute pressures within the banking system," El-Erian writes in a Financial Times blog.

There are two ways to look at the move, one sees a glass half full and the other half empty, El-Erian adds.

"The hope is that central banks are acting because, looking forward, they feel confident that other policymakers will finally catch up with a big and spreading debt crisis that has serious implications for growth, jobs and inequality. The fear is that they are acting because they feel that they must again pre-empt yet another set of potential disappointments."

The Federal Reserve points out the move is necessary in that providing cheaper dollars to the ECB will alleviate a credit crunch there.

"The purpose of these actions is to ease strains in financial markets and thereby mitigate the effects of such strains on the supply of credit to households and businesses and so help foster economic activity," according to a Federal Reserve statement.

U.S. banks, meanwhile, aren't threatened by liquidity issues, the Fed adds.

"U.S. financial institutions currently do not face difficulty obtaining liquidity in short-term funding markets. However, were conditions to deteriorate, the Federal Reserve has a range of tools available to provide an effective liquidity backstop for such institutions and is prepared to use these tools as needed to support financial stability and to promote the extension of credit to U.S. households and businesses," the Fed's statement reads.

Other experts agree with the Fed that the move is a helpful one, but point out it won't steer the global economy towards greener pastures and add the ensuing stock-market rally night not last.

"More people just bought stocks than know what a central bank swap line is," writes Peter Tchir of TF Market Advisors, according to the Wall Street Journal.

Furthermore, while stock markets may be shooting up on a relief rally, the dollar could suffer.

"Global central banks are opening the spigots and the casualty has been the dollar," says Kathleen Brooks, research director at Forex.com, MarketWatch reports.

"The extension of the dollar swap lines essentially means that dollars will be available cheaply and on request for the next 15 months to Europe's troubled financial sector, which will probably greedily eat them up after being starved of much-needed dollar funding since the summer."

Other analysts applaud the move, pointing out that while it won't solve problems, it is a step in the right direction.

"This is something that is very welcome. This will not solve all deep-based funding problems which are due to the sovereign debt crisis," says Silvio Peruzzo, an economist at RBS in London, Reuters reports.

"But there is an issue with dollar liquidity, especially with foreign currency and this measure addresses that. This helps the margin and also shows that Central Banks remain at unease with what certainly is very significant distress."

Other experts add they hope to see more concrete steps to support the financial system in Europe to follow.

"This is not a game changer for the debt crisis. It's relieving some strains but it's not meant to tackle the actual sources of these problems. There I think there is still quite a way to go on the policy ground. There needs to come a credible package," says Nick Kounis, Head Of Macro Research At ABN Amro, Reuters adds.

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Coordinated action from the world's Central Banks to inject liquidity into the European financial system may spark a global stock-market rally, but it won't solve the underlying issues plaguing the European economy such as a political unwillingness to carry out tough reform...
Wednesday, 30 November 2011 12:39 PM
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