Fed Restarts Foreign Currency Swaps

In a release late Sunday night, the Fed announced that it has agreed with other major central banks to reopen foreign currency swap lines in order to provide them with dollar liquidity through January 2011. While currency swap lines have been a frequent feature of central banks’ global activities, special swap facilities – like those announced on Sunday – are expected to be particularly useful to ease interbank liquidity pressures overseas at a time when the massive ($1 trillion) IMF-EU stabilization was announced.

At the start of the financial crisis in December 2007, special currency swaps between the Fed and other central banks were adopted "to address elevated pressures in short-term [U.S. dollar] funding markets" and operated until February 2010. Markets had responded very similarly to the Greek crisis as they did in the fall of 2008, when interbank funding costs rose because banks were unsure of each other's exposure to risk.

In essence, the Fed is trying to maintain global liquidity. Since the dollar is the world's reserve currency, it is critical that the Fed sends more dollars into the mix. The process works as follows: the Fed lends dollars to other central banks in exchange for foreign currencies as collateral at current exchange rates (so there is no exchange rate risk), the central banks then provide the dollars to financial firms in their jurisdiction as needed, and then central banks eventually repay the Fed the dollars they originally borrowed. The loans range in duration from one day to three months.

A Wall Street Journal article today has a helpful graphic showing how these swap lines work.

Fed officials and some policymakers have justified reinstituting the swap lines as a way to help prevent financial spillover effects from increasingly jittery financial markets. By limiting a potential rise in the cost of funding for US and other countries’ financial firms due to worry over risk, the Fed and its counterparts hope to minimize the impact of higher interest rates on the global recovery. The Fed points out that there is little risk to the taxpayer since the Fed’s swap contracts is with the other central banks alone. Some lawmakers, however, have been expressing opposition to the swap lines, arguing that the U.S. is taking part in yet another bailout. The administration has responded that providing additional dollar liquidity in the early stage of a crisis will be a cost-effective way to limit the crisis, as it was during the global economic and financial crisis which started several years ago.

Since the swap lines have the potential to add liquidity if drawn upon, there may be some small up-side risks for inflation over time, although this will importantly depend on the evolution of the economic and financial situation in Europe and the United States.