The separation principle is back – this time on the US side of the Atlantic. With today’s statement the Fed is basically embracing an ECB-style distinction between liquidity policy and monetary policy.
At the onset of the crisis some Fed officials thought there was something to the separation principle idea. Others thought it was complete nonsense.
As the crisis intensified Fed officials quickly reached a consensus that it made no sense to distinguish between monetary and liquidity policy in crisis conditions when both directly and substantially influence private borrowing rates and overall financial conditions. They thought the ECB was mistaken
One of the subtleties of yesterday’s complex package from the European Central Bank was that it attempted to re-assert the principle of “separation”. When the financial storm broke in August 2007, the ECB insisted, doggedly, that emergency financial market liquidity injections were not related to its monetary policy. That remained firmly aimed at controlling inflation and still very much determined the level at which it set the main policy interest rate. Indeed, in July last year the ECB famously raised the interest rate to 4.25 per cent because inflation appeared to be getting out of control.
After the collapse of Lehman Brothers a few months later, the ECB slashed its main policy rate and the distinction became harder to draw. It became impossible once, from June this year, the ECB