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Is Liquidity Enough?

Every week more liquidity is injected into the global banking system by the United States Federal Reserve and the European Central Bank. The average interest rate paid for overnight reserves in the US has been well below the 5.25% per year that the Fed still publicly says is its target.

But the market for overnight reserves now appears to be divided into three segments. Banks known to be healthy can borrow at much less than 5.25%. But banks facing possible liquidity problems – which the Fed wants to be able to borrow at 5.25% – are borrowing from the Fed itself at 5.75%, as are a few big banks that want more liquidity but don’t believe they could get it without disrupting the market.

Such a difference in the prices charged to “regulated banks” in financial markets is a sign of a potential breakdown. To date, the premiums charged are small: for an overnight loan of $100 million, even a one-percentage-point spread in the interest rate is only $3000. That reflects the small probability that the market is assigning to the occurrence of a full-blown financial crisis with bankruptcies and bank failures. In normal times, however, there is no such premium at all.

The fact that there is even a small liquidity crunch for banks implies larger liquidity crunches for less intensively regulated financial institutions, and even greater liquidity crunches for manufacturing and real-estate companies. It is hard to imagine that manufacturers are not now postponing orders of capitals goods, and that new home sales in America are not dropping right now.