Commentary on Political Economy

Wednesday, 1 April 2020


The Fed Is Settling Into Its Role as the World’s Central Bank

Allowing foreign central banks to access its repo facilities is effectively cost-free, benefits American lenders and borrowers, and cements the dollar’s dominance

The Fed’s unstated role as the global lender of last resort is increasingly becoming official.

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“They must lend to merchants, to minor bankers, to ‘this man and that man,’ whenever the security is good. In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them,” said British journalist Walter Bagehot in 1873, illustrating how central banks should behave during periods of financial panic.
Late on Tuesday, the Federal Reserve, which didn’t exist at the time of Bagehot’s magnum opus, came a step closer to the “this man and that man” part of the equation. The Fed will allow foreign central banks to use their U.S. government bonds as collateral for short-term dollar borrowing, under its new repo facility. The scheme begins April 6 and is scheduled to last six months.
Extending repo facilities to the other central banks of the world is both a minor and momentous move at the same time.
Share of foreign-exchange reserves globally,by currencySource: International Monetary FundNote: As of the end of 2019.
U.S. dollarEuroJapaneseyenPoundsterlingChineseyuan0%20406080
It’s minor because, as with the Fed’s repo operations at home, conducting them is effectively cost-free. This isn’t a bailout. It augments other existing facilities like the dollar-swap lines that the Fed has already expanded.
The new facility allows for countries with large dollar reserves in the form of Treasurys to more easily channel cash to dollar-squeezed domestic financial institutions, as Brad Setser of the Council on Foreign Relations noted when he proposed that the Fed adopt the tool.
But the announcement is momentous because it makes the Fed’s unstated role as global lender of last resort increasingly official. With its account at the New York Federal Reserve, even the People’s Bank of China could meet the criteria for the new facility if approved by the Fed. And the knowledge that the facility is likely to reappear in moments of high stress—as the “temporary” dollar-swap arrangements did—will make Treasurys even more attractive as a reserve asset than they already are.
It’s also good news for the U.S. on a solely self-interested basis. Overseas Treasury holders are now less likely to begin firesales of other dollar-denominated assets like corporate bonds when dollar funding gets tight. It is a functionally costless way to prevent worse outcomes for American financiers, businesses and, ultimately, the country as a whole.
Market action over the past month demonstrates that the threat to the dollar’s role from other currencies has been hyped. The world’s central banks aren’t scrambling for Chinese yuan. Despite the risk-free nature of Japanese, German and British government bonds, cross-currency basis swaps are pricing a significant premium for dollars.
As with many crisis-era measures, don’t expect this facility to ever fully disappear. It may be dormant during more stable times, but such tools are more often put away than retired forever. In future moments of acute stress, the Fed will return to the role of international lender of last resort with increasing comfort and confidence.

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