By Steven K. Beckner

SAN FRANCISCO (MNI) – Despite the positive market reaction to the
latest coordinated effort by central banks to ease European financial
strains, a high level of anxiety about the European debt crisis remains
among officials on both sides of the Atlantic.

No one is under any illusion that cheapened currency swap lines or,
for that matter, the latest efforts of European leaders to beef up their
bail-out fund, have ended the crisis.

Federal Reserve officials have been openly talking about how the
intensification of the Euro zone crisis has worsened downside risks to
the U.S. economic outlook just in the past few weeks. And the mood was
not significantly changed by Wednesday’s dramatic announcement, MNI
understands.

At the Nov. 2 Federal Open Market Committee meeting, Fed
policymakers downgraded their economic projections, in good part because
of the European situation. And now, officials acknowledge the outlook
for economic growth and unemployment has deteriorated further.

The Fed, European Central Bank, the Bank of Canada, the Bank of
England, the Bank of Japan and the Swiss National Bank announced
Wednesday morning they were extending and lowering the pricing of
currency swap lines “to enhance their capacity to provide liquidity
support to the global financial system.”

The Fed said the purpose of the new swap arrangements, which will
allow banks to obtain dollar credits at 50 basis points less, was to
“ease strains in financial markets and thereby mitigate the effects of
such strains on the supply of credit to households and businesses and so
help foster economic activity.”

The central bank coordination followed on the heels of a belated
agreement among European authorities to leverage, and effectively
increase, the euro zone’s bail outfund — the European Financial
Stability Facility.

The central bank actions were praised at the San Francisco Fed’s
Asia Economic Policy Conference.

“The central banks have just given us a fine example of global
policy coordination,” said University of California-Berkeley economics
Professor Barry Eichengreen, a former senior advisor to the
International Monetary Fund.

He was echoed by Ted Truman, former head of the Federal Reserve
Board’s international department.

That view is shared among officials. But, while stocks surged on
the announcement, it is recognized that the actions do not improve the
underlying European fundamentals.

But while the cheaper swaps ease dollar funding strains, they do
not address the underlying problem afflicting Europe, namely the loss of
investor confidence in a growing number of European governments’ ability
and will to curb deficit spending and manage their mounting debts.

As they have fled the Euro bond markets, the yields at which
governments must borrow to fund those debts has skyrocketed — and not
just in Greece and Italy.

The swiftly unfolding crisis has leapfrogged official efforts to
contain it, and what was considered nearly unthinkable just a few weeks
ago — an at least partial dissolution of Europe’s single currency
system — has become all too real a prospect.

One foreign official confided sadly that he now expects a
“break-up” of the euro zone.

Fed officials are hopeful that the European crisis can be defused,
but are bracing for further shock waves from Europe and preparing for
the worst.

Aside from aiding the ECB with liquidity problems, Fed policymakers
have made clear they are prepared to ease monetary policy further —
first through enhanced forward guidance on the duration of zero
short-term interest rates; second through additional large-scale asset
purchases to lower long-term rates.

When asked by MNI about the impact of the European crisis on the
U.S. economic outlook Tuesday, San Francisco Federal Reserve Bank
President John Williams told reporters the crisis has increased downside
risks and that the Fed is “watching this very carefully.”

He expressed the hope that European leaders “come up with a
solution that avoids a worsening of the crisis. We don’t want to see a
spreading of the financial crisis there.”

But Williams indicated he is prepared to increase U.S. monetary
accommodation if necessary to counter headwinds from Europe.

Responding to a similar MNI question at a press conference Tuesday,
Minneapolis Federal Reserve Bank President Narayana Kocherlakota said he
still thinks the Fed will need to “reduce accommodation” next year based
on projections of lower unemployment and stable inflation.

But he said the European crisis likely has lessened the need to
reduce accommodation, and he allowed for additional accommodation if the
outlook proves worse than expected.

Asked by MNI how the worsening of the European crisis since the
Nov. 2 FOMC meeting affects his policy calculations, FOMC voter
Kocherlakota responded, “I still see unemployment falling and the
outlook for unemployment falling but perhaps even more gradually. …

“On my baseline forecast, you’d still be looking to reduce
accommodation on my baseline forecast,” he said, adding that initially
reducing accommodation “should take the form of a shorter length of the
horizon before we start to raise rates … before we initiate exit.”

Fed Vice Chair Janet Yellen said Tuesday the world is at “a
dangerous moment” and emphasized the need for “global policy
coordination.” She said the Fed still has “some scope” to ease monetary
policy through either communications policy or additional asset
purchases.

** Market News International Washington Bureau: 202-371-2121 **

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