Central banks try to soothe markets

With stock markets in turmoil for a second week in a row, central banks around the world were forced to inject billions of dollars into their respective banking systems.

In the past 48 hours, about $323 billion worldwide has been pumped into the markets — the Bank of Canada put in more than $1.68 billion on Friday and about $1.64 billion the day before — and that seems to be calming fears somewhat. On Friday markets opened with heavy, triple-digit losses, but by midday, those numbers retreated to more normal trading levels.

Injecting billions into the financial markets seems to be soothing the market, but what are the reasons for such a move?

Avery Shenfeld, managing director and senior economist at CIBC World Markets, says central banks are trying to keep the overnight rate — the interest rate at which funds are borrowed for one business day — at their target rate. Canada’s current overnight rate is 4.75%.

If the rate rises, “the market would essentially wander,” Shenfeld explains.

“If a lot of banks are trying to borrow and not that many banks are trying to lend, then the overnight rate starts to drift up,” he says. “The central bank will put more cash in the banks so that now there are banks that do want to lend and drive that rate back down.”

With newspapers around the globe writing about the cash infusion, one might be forgiven for thinking it a rare event, but Shenfeld says it happens all the time. What’s unusual this time around is the amount of money that’s being added to the market.

“Central banks either add or subtract liquidity to keep the overnight rate at the target until they decide they want to change the interest rate and let it move,” he says. “What’s different is the magnitude of the injection that was necessary to hold the overnight rates at or near the targets they had previously set.”

Canada’s last big infusion of cash came on February 1, 2000, when the Bank of Canada added nearly $2.5 billion into the financial system. Normally, though, the Bank injects somewhere in the $100 million to $500 million range.

In most cases, adding money into the system is a one-day event; these large amounts aren’t piling on top of each other. The central bank borrows government securities from financial institutions, which provides them with cash to use. The Bank of Canada then sells those securities back the next day with one day’s interest. Conversely, if the overnight rate was trading below its target, the bank would sell government securities and repurchase them the next day.

“Part of this is mechanical,” says Shenfeld. “To avoid interest rates from rising, the banks have had to add extra liquidity.”

It’s hard to say what would happen if the Bank didn’t put cash into the market. Shenfeld says it’s never happened, so “we don’t get to observe where the rate would be in the absence of that funding.”

However, it’s a safe bet that if money wasn’t coming from central banks, the world’s economy would be in turmoil. And according to Finance Minister Jim Flaherty, the Bank’s approach is the right one. “I think what we need to do is exactly what the [Bank] is doing,” he told the Globe and Mail. “Monitor the situation and make sure there is adequate liquidity in the market so that the market functions.”

Filed by Bryan Borzykowski, Advisor.ca, bryan.borzykowski@advisor.rogers.com