Central banks' influence over markets wanes

The global money markets are seizing dominion over our economic destiny. The scant control that the monetary authorities still have of borrowing costs is slipping away.

And the misplaced trust in central bankers as the architects and guardians of financial stability is fading faster than the AAA rating on a collateralised debt obligation.

The combined efforts of the Federal Reserve, the European Central Bank, the Bank of England and their peers have failed to thaw the lending freeze that began in August. The rates commercial banks charge each other for dollars, euros and pounds are high and rising as the anticipated yearend squeeze nears.

The Bank of England was intimidated into cutting its policy rate by a quarter-point to 5.5 percent yesterday. The ECB has been bullied out of an increase for two consecutive months even though inflation is at its highest level in six years and money- supply growth is at its fastest in more than 28 years.

The futures market, meantime, suggests that there's a 56 percent chance that the Fed will cut its key rate by 25 basis points to 4.5 percent next week, and a 44 percent likelihood of a 50-basis point move.

None of this is soothing the lending rates that really matter. Three-month dollars cost 64 basis points more than the Fed's policy rate; the gap in euros is 88 basis points, while yesterday's U.K. central bank move widened the difference in pounds to 114 basis points from 90 basis points a day earlier.

"Lower interest rates won't resolve the problems in money markets,'' Robert Lind, chief economist at ABN Amro Holding NV in London, wrote in a research note this week. ``In spite of the Fed's nimbleness and the ECB's generosity with liquidity, the tensions in U.S. and euro-area money markets are just as pronounced as those in the U.K.''

European Union Economic and Monetary Affairs Commissioner Joaquin Almunia seems to agree. ``I know that many people are calling for lower interest rates,'' he said at a conference in Brussels this week. ``I have serious doubts that this would be a solution. Imbalances are at the origin of the present turbulences in the financial market.''

In August, banks were hanging on to their capital because they couldn't tell how severe a credit crunch the collapse of the U.S. subprime mortgage market might trigger. Now, they are loath to lend to the guy next door because he might still have landmines in his accounts.

UK central bank Governor Mervyn King says the reluctance to lend has deteriorated from a general concern about market liquidity to more intense worries about creditworthiness.

"It's not so much that people are worried about the amount of total losses in the subprime market,'' King said at the central bank's quarterly inflation briefing last month. ``There is genuine concern about what might happen to the capital position of the banks.''

We know what's happening to the capital position of the banks. It's getting worse. Why else would Citigroup Inc. sell a 4.9 percent chunk of itself to the Abu Dhabi Investment Authority to secure a $7.5 billion cash infusion? No matter how clever the mechanics of that fundraising exercise are, Citigroup is a forced seller of family silver in exchange for petrodollars.

The contagion isn't just spreading like wildfire across different asset classes; it is now threatening to unravel sections of the global financial framework and infect the world with systemic risk.

The Bank of England held a series of three-month money auctions in recent weeks that nobody attended. The risk of being outed as the recipient of emergency funds at a cost of 6.75 percent was enough to deter even the most-desperate British bank treasurer from applying.

The Fed has also struggled to attract borrowers to its discount window, even after Citigroup, Bank of America Corp., JPMorgan Chase & Co. and Wachovia Corp. each took very public $500 million loans at 5.75 percent on Aug. 22 to try and lead their fellow horses to the trough.

Slashing the rates at which emergency central bank money is available won't be enough to defrost the money markets. If financial institutions don't trust the ability of their central banks to guarantee anonymity, they still won't borrow, undermining the monetary framework.

"This poses a question about the social contract between the authorities and the banking system, where central banks provide funds in unlimited quantities against collateral but at a penal rate,'' Paul Tucker, the Bank of England policy maker with responsibility for monitoring markets, said last month. ``If it's stigmatized to draw those funds, then there is a question about how the system will function over the future. By the future I mean 10, 20, 30 years.''

By losing control of interest rates, monetary authorities have ceded control of the economy's steering wheel to the markets. And while the Fed congregates every six weeks to sniff the economic air and the ECB and the Bank of England meet monthly, traders and investors gather to judge the state of the financial world almost every second of every minute of every day. Brace yourself for a bumpy ride into 2008.