The large flow of funds from the ECB to stem the rise in overnight funding rates has been unprecedented. Formally, there has been a strong shift in money demand in response to a change in risk appetite. The strong shift in demand caused overnight rates to soar. Money supply had to increase to bring rates down to their target.
The rise in rates and ECB action has been in response to the halting of withdrawals from three investment funds offered by BNP. While these are investment funds, the trickle-down effect is that there to be a liquidity crisis in Europe from a bank closing funds. We are seeing what may be called the Trichet put in action. This could be similar to the Greenspan put which protected the US stock market in the 1990's.
A key role of the central bank is to provide liquidity in a crisis. The harm to economies when this action has not been taken is well-documented. The issue is whether this represents a crisis and whether a short-term spike in rates should be dampened immediately by the central bank. Nevertheless, the greatest fear may come from the law of unintended consequences. Yes, the major European equity markets are down over 2 percent for the day, but what will be the longer term impact of this response to this short-term funding shock? If the market believes that the ECB will help out when there are bad investment decisions from securitization problems, it gets the wrong signal.
The central bank response may have been too quick. A period is needed for the market to find its appropriate level and not have a central bank provide a level of protection from these short-run shocks. There is no sub-prime problem in Europe although it has some major real estate problems in a number of countries. The investors in these funds are relatively sophisticated and high net worth. Short-term shocks should be monitored but it may have been early for central bank action and a signal that the ECB will try and make everything normal.
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