Greece and Puerto Rico Crises Could Mean Fed, Again, Becomes World's Central Bank

NEW YORK (TheStreet) -- If the Greece and Puerto Rico debt crises cause worldwide panic, scaring investors and causing liquidity to dry up, the U.S. Federal Reserve just might step in to help, becoming, in essence, a central bank to the world. 

You read that right: The Fed must be prepared to help maintain liquidity in world markets. There's precedent. 

The Federal Reserve was very active in during the Great Recession in supplying reserves to other central banks throughout the world through central bank liquidity swaps, which are deals with foreign central banks that allow the Fed to use their capital to provide liquidity in the U.S. -- and visa versa. According to the Federal Reserve's H.4.1 statistical releases, swaps were provided to central banks after the economic recovery began in the United States as other nations continued to face their own recovery problems.

Furthermore, the Federal Reserve also increased excess reserves in the banking system by more than $2.5 trillion during the economic recovery. Tracing how the banking system used this liquidity through the Fed's H.8 statistical releases, one can observe that banks channeled well more than $600 billion of these reserves to off shore uses, primarily to supply liquidity to the banks not located in the U.S.

The classical response of the central bank to investors running for safety when times get uncertain is to make sure that banks and financial markets are sufficiently liquid so that further problems don't exacerbate the existing situation. 

That kind of situation is exactly what was seen on Monday, when markets around the world plunged. Further, the two major safe havens for investments, the U.S. Treasury bond market and the market for German bunds, both experienced substantial inflows of money. The yield on the 10-year Treasury bond dropped to 2.33% at the close yesterday from 2.48% at the close on Friday. In Germany, the yield on the 10-year bund dropped to 0.78% percent yesterday from 0.85% last Friday.

Still, the big question on investors' minds when it comes to the Fed is will it raise interest rates come September? 

Raising short-term interest rates during a period of time when world financial markets are experiencing liquidity problems will not be something that officials at the Federal Reserve will do.

Could we be facing a liquidity crisis in September? Today there are questions about Greece and the European Union, and Puerto Rico. Just yesterday, Benn Steil, a senior fellow at the council of foreign relations tweeted "Ukraine Finance Minister Natalie Jaresko: Ukraine default 'theoretically possible.'" And we have read that "France and Italy are the Next Causalities of the Credit Bubble."

Yet, liquidity crises are not long-lasting affairs. As uncertainty settles away, investors become more confident in their decisions and the search for a safe haven for investments dissipates. Financial markets return to a more normal setting.

Over the next week or so, the situation with respect to Greece and the European Union should gain greater clarity. The parameters of the Puerto Rico default should be settled. And, we will, as always, have more information on the status of all other national economic problems.

Then we can get back to where we were before, worrying about the fact that U.S. economic growth is so modest, worrying about the strength in the labor market, and about the value of the U.S. dollar. It is those issues that the Fed will consider when deciding whether to raise short-term interest rates in September, or not.

 

  This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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