The Federal Reserve may be politically hampered in requesting a currency swap with the European Central Bank even if such a move could help relieve a squeeze in money markets, said analysts at Wrightson ICAP in a note to clients on Monday.
"The Fed would have a hard time explaining to Congress why it is reasonable to provide financing to support foreign investors caught in the subprime problem when the Fed is not willing to underwrite dicey real estate loans at home," said Lou Crandall, chief economist at Wrightson ICAP.
Crandall, a well-known money market economist on Wall Street, said that the dollar-funding needs of European banks was at the root of the cash crunch in money markets that prompted hefty injections of funds by the ECB and Fed on Thursday and Friday.
Worries about the exposure of some European banks to credit instruments backed by U.S. subprime mortgage loans unleashed the turbulence in money markets late last week.
The ECB pumped in a record 95 billion euros ($130 billion) on Thursday, followed by the Fed's $38 billion on Friday and rare statement pledging to help restore the orderly functioning of financial markets.
The troubles, which drove the fed funds rate up to 6% on Friday only to plunge down to near zero after the U.S. central bank's actions, have stirred speculation the Fed and ECB may set up a currency swap. The fed funds target is 5.25%.
Under a currency swap, a central bank can draw on the funds of a fellow central bank to provide short-term money.
Crandall also said a currency swap would weaken the Fed's hand in fending off proposals from Congress to use its balance sheet for interventions against any country's labelled currency manipulators, as is being mulled by the Senate.
The Fed set up currency swaps shortly after the Sept. 11 attacks with the ECB and Bank of England to keep dollar funds flowing to Europe, but the ECB only used the facility for three days. Crandall said the creation of the swap line alone back then helped get more money flowing again.
In the past two years European banks have become very reliant on raising their funds in the U.S. interbank market. The drying up of liquidity in London hours on Thursday then left banks scrambling for scarce funds and created a panic, he said.
Further ECB injections of euro funds would not help alleviate the dollar demands of banks, and money markets are likely to stay volatile until European banks show they can meet their funding needs calmly, Crandall said.
The fed funds rate is likely to push higher in early trade but crash late in the day as on Friday.
U.S.-based economists at Goldman Sachs said in a weekly note to clients that the Fed would likely try to resolve the problems by supplying more funds rather than cutting the fed funds rate.
"The Fed would prefer to resolve the current crisis through an increased supply of credit at the current funds rate target rather than a reduction in this target. This is because the current problem is one of availability of funds rather than cost," the Goldman economists said.