Helicopter money redux

The end of the year infusion of funds by central banks has taken on a much bigger dimension with the ECB providing $500 billion in short-term funding to banks. You talk about money dropping from the sky as a Christmas gift to the global banking system! And, I thought those who are naughty do not get presents.

The reaction in money markets was swift. Short rates have fallen dramatically. While there is still a wide spread between LIBOR and Treasury rates, the infusion of funds is doing what one would expect. Yet, it gives pause to think about the size of intervention needed to get the very short rates to decline for the end of the year.

The current story is one of circular funding. Banks funded credit but did not want them on their balance sheets so they set up SIV’s. The SIV’s cannot sell their commercial paper so the banks have had to put these assets back on their balance sheets. The same institutions that did not want to fund the SIV’s now do not want to fund the banks, so the central banks have to be the lenders of last resort. If they are not providing the funds, the credit markets will have to shrink and credit conditions will have to tighten.

A friend who is a money market manager mentioned that the Fed wants to keep the Fed funds cuts separate from the TAF funding, but a dollar of new money is the same regardless of the source. The economy does not care how the funds are dispersed. The result is the same especially if the market perceives that these funds that will be needed for some time.

This cash infusion is like a cold medicine. It will mask some of the symptoms but it does not cure the cold. Money is being loaned to needy banks, but what does it mean to be in need at this time. More importantly, what will happen in January when some of this short-term funding matures? The root cause of bad credits held by some banks will not be resolved in the next few months. There will not be more liquidity in January and there may not be more buyers of subprime debt after the end of the year.

This money will have way of finding its way to what will be considered good assets and consumer purchases. This will mean greater inflation. Even if it does not show-up in consumer price indices, there will be a problem of asset price inflation as funds are reallocated in ways that may be unintended by the central banks. We are already seeing the reaction in stock indices in Europe. If the intention is to provide needed funds for banks which are not able to raise them at reasonable rates, the reaction should not be an across the board increase in stock prices. Of course, the stock reaction would be expected if the funding is anticipated to last.