Policymakers only having limited money market success

By Jamie McGeever - Analysis

LONDON (Reuters) - Official interest rates and future rate expectations are tumbling around the world, dragging critical interbank lending rates lower too, but failing so far to turn the trickle of credit into a more sustained flow.

As central bankers in industrialised nations move closer towards essentially a collective zero interest rate policy -- ZIRP -- to combat economic depression and deflationary pressures, banks are reluctant to actually lend at any cost and demand for credit from borrowers is dwindling.

There are signs the gradual improvement in money market conditions following the collapse of Lehman Brothers in mid-September is grinding to a halt; banks are depositing large amounts of cash at the central banks rather than lending it out and many key spreads are widening again.

As the year-end approaches -- traditionally a period of illiquidity as banks window-dress balance sheets for accounting purposes -- U.S. Treasury Secretary Hank Paulson's U-turn on the Troubled Asset Relief Program went down badly in money markets.

Dealers were spooked by Paulson's sudden shift: it was only a short while ago that Congress approved a drastically modified version of the plan after tortured negotiations and Paulson said buying up toxic mortgage-related assets was the way forward.

The prospect of large chunks of these assets now being left to fester on banks' balance sheets creates more uncertainty about their values and reignites fears about bank writedowns, cash hoarding and counterparty risk.

"Uncertainty, as much as anything else, is the enemy of a return to more normal financing conditions and Paulson ... evidently increased rather than decreased money market participants' uncertainty," said Laurence Mutkin, head of European rates strategy at Morgan Stanley.

"(Central banks and governments) need to avoid giving markets reason to fear that greater uncertainty lies ahead. With confidence still so fragile, that could undo a lot of good work -- and widen Libor/OIS spreads -- quite rapidly," Mutkin said.