Fed Restarts Currency-Swap Tool With ECB in Effort to Contain Debt Crisis

The U.S. Federal Reserve will restart its emergency currency-swap tool by providing as many dollars as needed to European central banks to keep the continent’s sovereign-debt crisis from spreading.

The swaps with the European Central Bank, Bank of England and Swiss central bank, as well as the Bank of Japan, will allow them to provide the “full allotment” of U.S. dollars as needed, the Fed said late yesterday and today in statements in Washington. A separate swap line with the Bank of Canada will support as much as $30 billion, the Fed said. The swaps were authorized through January 2011.

The Fed action was a complement to European policy makers’ announcement of an unprecedented loan package worth almost $1 trillion to stop a crisis that threatened to shatter confidence in the euro. The U.S. central bank on Feb. 1 had closed all swap lines opened during the last crisis, triggered by the subprime- mortgage meltdown in 2007.

“If there is one thing the Fed doesn’t like, it is systemic risk,” said Torsten Slok, an economist at Deutsche Bank AG in New York. “Early signs of systemic risk were brewing in the financial system last week, and if policy makers had not taken action this weekend, then this would also have been a threat to the U.S. financial system.”

Photographer: Melissa Golden/Bloomberg

The U.S. Federal Reserve building stands in Washington. Close

The U.S. Federal Reserve building stands in Washington.

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Photographer: Melissa Golden/Bloomberg

The U.S. Federal Reserve building stands in Washington.

Stocks surged around the world today after yesterday’s actions, with the Standard & Poor’s 500 Index rising 3.8 percent to 1,152.79 at 1:29 p.m. in New York. The euro strengthened against the dollar, gaining 0.4 percent to $1.2807 after rising as much as 2.7 percent. The euro traded at $1.5134 in November.

Stress Sign

In a swap, central banks exchange foreign currency with an agreement to reverse the transaction at a later date. The central banks will then lend the dollars at fixed rates to firms in their countries. Dollar liquidity tightened in London last week amid concern financial institutions are holding too many assets of Europe’s most-indebted nations.

“My concern was whether or not the financial concerns for financial institutions in Europe would spill over into the United States and affect our incipient recovery,” Philadelphia Fed President Charles Plosser said today in an interview on CNBC. “Hopefully the actions that have been taken will prevent that from happening, and the Fed’s role in this, in renewing the swap lines, was an effort to help ensure that that didn’t happen.”

Libor Fell

The London interbank offered rate, or Libor, for three- month loans slipped to 0.421 percent today, from 0.428 percent on May 7, the highest since Aug. 17, according to the British Bankers’ Association.

Plosser said his U.S. economic outlook is “still pretty upbeat” and projected average job growth of about 250,000 to 300,000 positions a month for the rest of the year.

Fed officials aren’t sure what the immediate demand will be for dollars or how much the U.S. central bank’s balance sheet will grow from its current level of $2.33 trillion. The ECB said its first offering will take place tomorrow. The prior incarnation of the swaps peaked at $583.1 billion in December 2008, with deals encompassing 14 other central banks.

“We have a banking system that is fragile, and those banks are exposed to European banks,” said David Kotok, chairman and chief investment officer at Cumberland Advisors Inc., which manages about $1.4 billion in Vineland, New Jersey. Further volatility in Europe would “impact us as well,” he said.

Rising Costs

Rising costs in the market for dollar loans between banks began to show “distrust” in the financial system, Kotok said. “As soon as you see that, you know you have systemic risk.”

This time, the Fed’s swaps come amid increasing political scrutiny. Congress could ask why the U.S. central bank is expanding the supply of dollars to help smooth disruptions caused by fiscal imbalances in Europe.

Senator Bernard Sanders, a Vermont independent, wants the Government Accountability Office to look into Fed lending facilities during the crisis, including swap lines with foreign central banks, such as the $20 billion facility the Fed opened with the ECB in December 2007.

A vote on the Sanders amendment could come as soon as May 11 as Congress proceeds with the most sweeping overhaul of financial regulations since the Great Depression.

“Many members of Congress are deeply suspicious of the Fed’s interventionist instincts,” said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey. “Bailing out Wall Street caused enough resentment; appearing to bail out Greece would be even more problematic.”

‘Rile Up’

“The Fed cannot afford to rile up its congressional critics while the financial reform bill is still in play,” Crandall said before tonight’s announcement.

The Fed said today it’s not at risk of any losses on the swaps, because the ECB is obligated to repay the dollars the Fed provides at the same exchange rate.

The weekend’s events had echoes of the financial crisis in 2008. Fed policy makers acted after getting formal requests from the other central banks late on May 8, a Saturday, following informal requests toward the end of last week. The FOMC convened a meeting around midday yesterday and delegated authority, with conditions, for Chairman Ben S. Bernanke to approve the swaps. The vote of Fed policy makers was unanimous.

Fed officials considered possible political consequences of their decision at their weekend meeting. Bernanke told his colleagues that the Fed had to do what is right for the U.S. economy, while providing more transparency to Congress. The Fed said it will publish weekly reports on the swaps and will “shortly” release the contracts with the other central banks.

Many Risks

Officials at the Fed saw multiple risks to the U.S. expansion from continued turmoil in Europe, such as crimped trade, declining confidence, and financial volatility.

The Fed’s move may pale next to the agreement by the 16 euro nations to offer financial assistance worth as much as 750 billion euros ($971 billion) to countries under attack from speculators. The ECB said it will counter “severe tensions” in “certain” markets by purchasing government and private debt.

“The Fed action is a fringe development here,” said Axel Merk, president and chief investment officer of Merk Investments LLC in Palo Alto, California. The more important development is that “Europe is getting its act together,” he said.

To contact the reporters on this story: Scott Lanman in Washington at slanman@bloomberg.net; Craig Torres in Washington at ctorres3@bloomberg.net.

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