Radical moves by the Federal Reserve today

Discussion in 'Economy' started by gonegolfin, Oct 6, 2008.

  1. gonegolfin
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    gonegolfin Member

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    I wanted to punch out a quick update tonight as there were a couple of very significant moves made by the Federal Reserve today that merit serious attention. The first is that the Fed increased the size of the Term Auction Facility (TAF) yet again after money markets were frozen solid today. Last week, the Fed announced an increase in the TAF from $150 billion (two $75 billion 28-day auctions held every two weeks) to $450 billion. Well, the Fed doubled the size of the TAF (to $900 billion) before the first auction under the announced increases from last week was held (the first auction was today). The second is that the Fed announced that they would now pay interest on excess reserves held by banks on deposit at the Federal Reserve.

    The federal funds rate is the rate paid by banks for overnight funds. Banks use the federal funds market (daily) to acquire cash needed to meet the minimum level of reserves required by the Fed. Banks that have excess reserves, lend their excess reserves into the federal funds market such that they can earn interest on those reserves instead of having them lie in a bank vault or on deposit with the Fed, neither of which pays interest (until now). The Fed attempts to keep the trading federal funds rate at its target rate for federal funds (this is the interest rate you commonly hear about in the financial news) by conducting open market operations (sometimes daily) that manipulates the amount of liquidity in the system. These open market operations either inject reserves into the system or drain reserves depending on the supply and demand for money, relative to the rate where federal funds are trading. With the move by the Fed to pay interest on excess reserves, the Fed's target rate for federal funds has been effectively neutered and places a floor under the federal funds rate. This is because a bank will not lend overnight funds to another bank at or below the rate that the Fed pays for excess reserves. Why accept less interest in the federal funds market and take on risk by lending to another banking institution when you can get paid that rate of interest by the federal reserve? Such a move allows the Fed to begin their program of quantitative easing (creating new money) as they no longer need worry about the federal funds rate plummeting to 0% (which would happen if significant amounts of reserves were injected into the system as the supply of money would explode relative to demand). Of course, this further discourages banks from lending to one another which is the chief problem that the Fed is attempting to solve.

    In a related move, the substantial increase in the size of the Term Auction Facility (TAF) to $900 billion, also paves the way for the Fed to engage in quantitative easing (print money). As mentioned above, the Fed now paying interest on excess reserves allows the federal funds rate to remain intact which will also keep treasury rates from crashing into the earth. The $900 billion is about the size of the entire Fed balance sheet, which has been littered with debt of questionable quality from past auctions and lending operations. The $900 billion is immensely more than the amount of treasuries remaining in the Fed portfolio (currently about $484 billion as of Wednesday 10/1). Hence, full sterilization of Fed liquidity injections is no longer even possible. This means that the monetary base, which began to grow measurably a couple of weeks ago (but only grew just over 2% since August '07), is set to increase rapidly and significantly. Remember that the monetary base is the base level of money for which the Fed has control. This money then bubbles down to the banks. Banks then excercise fractional reserve lending to further increase the money supply (this is from where the real money supply increases come). Assuming that the banks do begin lending again and we do not fall into a deflationary spiral (which still could happen), the result will be incredible inflation once this money finally does work its way through the system.

    If the gridlock in the money markets continues, the Fed may have no choice other than to guarantee Libor deposits and commercial paper.

    Got Gold?

    Brian
     
  2. Paulie
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    Paulie Platinum Member

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    Not nearly as much as I would have liked to have at this point. How long before the market would actually see this new money and respond? Are we talking weeks, months, or years until consumer prices skyrocket?

    Is this to fend off deflation? Help me understand why they are printing NOW. Is it simply because they've run out of sterilization ability, and this was inevitable anyway?

    I can't help but think this was a long-planned event, and we are about to witness the endgame. Please do whatever you can to explain why I'm wrong.
     
  3. gonegolfin
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    gonegolfin Member

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    We do not know if the market will respond to the policies being implemented. Some nasty deflationary forces are being fought. But I can now say that the Fed is throwing its chips onto the table. It will be interesting.

    I think that Bernanke was trying an experiment to determine if the Fed could use its balance sheet to restore order. I think he understands that quantitative easing is dangerous (especially given the amount of Dollars held overseas) and that it was to be used as a last resort. I think that he has determined that the Fed is down to its last option (as the debt swaps have failed) ... which may or may not be able to stave off this deflationary crisis.

    Brian
     

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