the fed took advantage of the new powers it was granted in the financial stabilization bill by announcing that it will begin to pay interest on reserves it holds on behalf of depository institutions, an action that gives the fed the ability to engage in a quantitative easing of monetary policy and which can be as powerful as interest rate cuts, maybe - maybe - more so in the current environment.
today's announcement has the potential to be powerful, with the fed saying that it will simultaneously boost the size of its term auction facility, the facility the fed created last december, to as much as $900 billion by year's end from the $300 billion size it set last monday, and the $150 billion facility that was in place from may until last monday.
this massive increase in the size of the taf could not have been possible without the newly granted authority given to the fed to pay interest on reserves, a technical provision that gives the fed the ability to literally flood the us financial system with money without it impacting the federal funds rate. this is because banks will "sell" or deposit their excess money at the fed, rather than chase the funds rate lower when they have excess money to sell.
in the past, when the banking system has been flush with cash, banks, particularly smaller banks, have attempted to sell their excess money to other banks, often chasing the fed funds rate lower in an effort to avoid holding balances earning no interest.
in recent weeks, for example, the funds rate has fallen to close to 0% nearly every day because banks are competing with other banks to find buyers (borrowers) for their excess funds.
i said that the increase in the taf to $900 billion could not have occurred without the new authority given to the fed, but this is not entirely true. The fed could have, as has been the case, recently, borrowed money from the treasury department, which has been selling treasury bills and handing the money over to the fed. The problem with that operation is that it is essentially robbing peter to pay paul -- taking money out of one pocket and putting it in another.
second, the fed, by having to rely upon treasury for funds, loses some of its independence, which is, of course, undesirable. now, the fed can just turn on the printing press -- literally.
by going solo, the expansion of the fed's balance sheet will be new money, which if lent can multiply substantially. the rule of thumb is that each dollar of reserves can result in $10 of new lending (because the first bank can lend 90 cents; the second bank 81 cents; and so forth, after deducting the 10% reserve requirement).
whether this happens is, of course, up in the air and depends upon a restoration of confidence first. eventually, to quote adam smith, "the natural effort of every individual to better his own condition, when suffered to exert itself with freedom and security, is so powerful a principal that it is alone, and without any assistance, capable of carrying a society to wealth and prosperity."
before people start behaving as adam smith says they inevitably do, they must get over the shock of recent events, a process that in 1998 and 1987 took about two to three months, judging by libor and the ted spread. frayed nerves will calm in this time frame and catch up to the facts, which is that the fed, with its new authority, is flooding the financial system with money -- literally printing money -- at a time when the treasury is set to remove troubled assets from the banking system. rapid money growth means higher prices, beginning first with financial assets and then real assets.
hearing the printing presses roll at the fed might seem to present an inflation problem, but that is the wrong bet to make right now. the bet to make is on a rise in the prices of financial assets, sticking with the highest-quality equities, agency securities, agency mortgage-backed securities, and even corporate bonds.
the emerging markets will also have their comeback, as the spreading of market-capitalism is a secular idea and has a ways to go. europe looks last in this one because it can't have a uniform banking solution (not as easy as in the us), and because it is lagging behind the us in the economic cycle. the ecb has also been a bit stubborn on rates, to be very nice about it.
i'd very, very much like to see the fed compliment its action with a big rate cut, as much as 100 basis points in order to steepen the yield curve, widen net interest margins and hence make banks more profitable. as investors in banks, we the public have a vested interest now more than ever. today's action reduces the need for a cut, but this is a problem that should be attacked from every front. if markets are still sliding by tomorrow, the fed should act to stabilize markets with a deep rate cut on tuesday morning.