The Fed has already cut interest rates

Discussion in 'Economy' started by gonegolfin, Oct 2, 2008.

  1. gonegolfin
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    gonegolfin Member

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    The Federal Reserve has essentially already cut its target interest rate for federal funds, despite not making an announcement of a new target rate. Federal funds have traded between 1.08% and 2.03% percent over the last nine trading days. The next high (after 2.03%) was 1.56%. Federal funds averaged 1.15% yesterday.

    This means that since 9/19, the Fed has not been sterilizing all of its liquidity injections.

    Brian
     
  2. dilloduck
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    dilloduck Diamond Member

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    So the money spigot is still wide open ?
     
  3. gonegolfin
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    gonegolfin Member

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    It has opened a bit in the last couple of weeks (with the foreign currency swaps). It has been shut mostly for the last year as the Fed has been simply swapping good debt for bad debt, instead of injecting a bunch of net new liquidity. The monetary base has increased a little over 2% since August of '07.

    We will know more when the first set of new TAF auctions are held. If the Fed does not sterilize this new $300 billion of injections, then we will know that the money spigot is wide open and you will see the monetary base take off.

    Brian
     
  4. dilloduck
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    dilloduck Diamond Member

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    explain 'sterilize', if you don't mind.
     
  5. gonegolfin
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    gonegolfin Member

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    Let's say that the Fed loans $75 billion dollars at auction to a set of banks, in return for collateral accepted by the auction (I am using the Term Auction Facility as an example here). That collateral may be agency bonds (Fannie Mae, Freddie Mac debt) or it may be mortgage-backed securities, as an example. If this is all the Fed did, this injection of liquidity into the system (newly created money) would cause the federal funds rate drop. And it may drop below the Fed's target rate for federal funds. This is obviously inflationary.

    So, the Fed sterilizes some or all of this injection (according to their goals with respect to the federal funds rate) by selling treasuries from their portfolio. When the Fed sells treasuries in the open market, money is removed from the money supply. This is obviously deflationary. Thus, the intent here is to offset some or all of the original liquidity injection(s) (sterilization). So, effectively, it is an indirect method of swapping treasuries for the above mentioned collateral. But I think that an unintended consequence of this is that the healthier banks (the ones that actually have some cash to lend) purchase the treasuries instead of lending into the economy (another example of government debt crowding out real economic investment). Meanwhile, the less healthy banks that took the cash loan in exchange for the collateral are the least likely to use this money for lending purposes. They may be using it to help stay solvent.

    For most of the past year, the Fed has been piling up less credit-worthy assets on its balance sheet in exchange for much higher quality debt (treasuries). Thus, the Fed has taken on substantially much more credit risk.

    Brian
     
  6. Toro
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    Toro Diamond Member

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    There was tremendous volatility in the Fed funds market this week. The rate was rarely at 2% and ranged between 0.125% and 7%. It was amazing to watch it.

    I wouldn't necessarily say the monetary spigot was open this week, given that swap spreads and the TED spread blew out to way above all-time highs. However, the Fed has expanded its balance sheet pretty dramatically, which will lead to more monetary creation down the road.

    Money velocity is also slowing.
     
    Last edited: Oct 3, 2008
  7. dilloduck
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    dilloduck Diamond Member

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    and thereby making a financially riskier move with taxpayer money ?
     
  8. gonegolfin
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    Reserves expanded by about $91 billion in the week ended Wednesday (10/1). But most of the Fed balance sheet expansion was due to an expansion in the TSFP (Treasury Supplemental Financing Program), which is not inflationary as the Treasury is auctioning treasuries and depositing the proceeds with the Fed in a special Treasury account (on the liability side of the balance sheet). This has fooled a lot of folks in the press and media.

    Brian
     
  9. gonegolfin
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    Well, the Fed is swapping good debt for bad debt. This is obviously risky for our currency and our economy. But at the same time, the Treasury is issuing more debt (this does not even include the debt that will be auctioned to fund the bailout bill) and the Fed is using some of it to expand its balance sheet in a non-inflationary manner. Typically when the Fed expands its balance sheet, it does it by buying treasuries (increasing reserves as new money is spent to buy the treasuries).

    Brian
     
  10. dilloduck
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    Why does this sound like money laundering ?
     
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