Izabella Kaminska discuss the implications of the news that LIBOR, whose interest rate marker is a benchmark for determining market liquidity, has been fabricating its interest rates:

Central banks, in many cases, target Libor explicitly. That is to say, monetary policy decisions are often moulded around attempts to influence the rate.

Thus, if the rate is manipulated into being something it is not, there can theoretically be dire consequences for market liquidity.

From the point of view of central banks the course of action is simple: the lower the Libor rate, the less liquidity the market needs.

Thus the more Libor isunderreported, the greater the misjudgment of liquidity needs by the central bank.

The greater the undersupply of liquidity, meanwhile, the higher real Libor rate soars, the greater the attempts to manipulate it downwards.

And so the vicious circle goes. Until eventually central bank actions become completely misaligned with reality, and Libor becomes impossible to hold back because the undersupply of liquidity in the markets is so pronounced.

It will be interesting to see how central banks adjust their monetary policy in light of the fact that one of the most important benchmarks of measuring liquidity is now completely unreliable.  Needless to say, this will have a huge impact on monetary policy going forward.  Izabella notes that there has been a debate being had on whether it’s wise for central banks to use unsecured rate indexes as a benchmark.  It appears as if some of the initial chatter from earlier this year suggests that banks may shift to using short-term repo rates as a benchmark target to measure liquidity.  Time will tell if this is a more effective tool.  But at this point, it’s almost certainly preferable to the sham LIBOR benchmark.

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