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The Fed's New Auction System


The Fed is considering a "new auction system" that takes away the stigma from the discount window

I explained yesterday why the Fed might substantially lower the discount rates. Essentially, no bank wants to lend out its capital (because it can't), so the Fed as a lender of last resort (which it really shouldn't be and can't) is the only entity willing to lend (the only entity willing to create credit out of thin air and devalue the dollar).

But all in all, there is a stigma attached to borrowing from the Fed through the discount window: the banks have to disclose it and it illustrates severe financial weakness to their shareholders and depositors. For example, one source of liquidity that banks and companies like Countrywide (CFC) have been using is the Federal Home Loan Bank system where they don't really have to tell anyone. This has saved the banking system so far but is tapped out.

So the Fed is considering a "new auction system". Essentially, what the Fed is doing is taking the stigma away from the discount window--the Fed will lend directly to banks and the banks don't have to tell anybody. Theoretically, the Fed could make these quiet loans for indefinite periods, thus giving banks more permanent capital (it's really credit, but banks call it capital).

I have a feeling the Fed moved less yesterday than expected because foreign investors (foreign central banks) were crying foul. A bigger move would further deteriorate the dollar and thus their investments in the dollar. It would also hurt their exports. They are getting pretty tired of this game and trade pressures are building.

The Fed knows that higher stock prices are important to reflate since 90% of global liquidity is dependent on high asset prices as collateral. Thus they are desperate to finance banks' collateral values. How to do that? The only way is to lend directly to them.

The plan won't work. Under the repo/fractional reserve system the debt can be hidden because it is spread out among many banks. Tthe Fed lending $10 billion (and thus their balance sheet rising by $10 billion) will turn into $500 billion as other banks lend that money out and only keep a fraction of it for themselves. This is not working. Under the "new" plan the Fed will lend directly to each bank. If they want to create $500 billion of new credit the Fed's balance sheet will increase $500 billion.

This will be obvious to foreigners just like a big cut in the discount rate. This is why gold is up this morning in response to this "new" plan which is really just a hidden discount rate cut: if the Fed is willing to pervert its balance sheet to this extent the dollar will fall.

And gold (in dollars) will go up.
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