Funding conditions in Europe have tightened markedly in recent months as a result of rising concerns over sovereign risk. The 3-month EURIBOR-OIS spread has more than tripled and bank access to longer-term unsecured financing has been sporadic at best. The retreat of cross-border flows has been the determining factor. For example, U.S. money market funds have sharply reduced their exposures to European banks. As a result, U.S.-dollar funding pressures have been particularly acute, prompting the ECB to extend its U.S.-dollar liquidity facilities.
The deterioration in funding markets in Europe has had important spillover effects on broader European financial conditions. Lending standards for businesses and households have tightened significantly and, partially as a consequence, economic momentum has slowed. Indeed, despite the major steps taken in recent weeks by European authorities, the Bank of Canada now expects the euro area to experience at least a brief recessionas a result.
The effects are not limited to Europe. Global financial conditions have tightened significantly. Market-making activity has decreased, with U.S. primary dealer inventories of corporate bonds down about 40 percent since April to a level of about one-quarter of their pre-crisis peak. More importantly, relative to levels over the previous two years, new issuance volumes have fallen by about 80 percent in the U.S. high-yield market, and roughly 25 percent in investment-grade corporate markets over the past three months.
As global liquidity recedes, volatility is increasing and activity falling. The effect on the real economy will soon be felt.
And yet Newt Gingrich wants to fire Ben Bernanke on the grounds that monetary policy is too tight.