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Understanding Fed Liquidity Injections


A clear, play-by-play explanation.

Editor's Note: The following originally appeared on July 11, 2003 and, in light of current events, has been reprinted here for the benefit of the Minyanville community.

A common Minyan question: For the financially challenged among us (like me) please explain what exactly it means for the Federal Reserve to be injecting liquidity, and how that liquidity gets into the stock market.

The Federal Reserve injects liquidity into the U.S. financial system primarily by conducting open market operations with broker dealers and money center banks. These operations involve buying U.S. Treasury and federal agency securities like treasury bills and treasury notes from these institutions, which then have excess liquidity to do things such as lend it out to customers for consumption and business purposes.

These operations have names like reverse repurchase agreements (the Fed buys T-bills at a discount to face while agreeing to sell them back in around 30 days), which provide temporary liquidity and coupon passes (the Fed buys short term notes of a specific issue with no recourse), which provide more permanent liquidity.

Outside of these operations, the Treasury Department, in consultation with the Fed, can provide liquidity indirectly and affect the yield curve by purchasing longer term bonds. The Fed can also directly lower interest rates, specifically the discount rate: the rate charged to depository institutions on loans form their Federal Reserve Bank's lending facility (the discount window). The Fed can also lower reserve requirements regarding the amount of funds that depository institutions must hold in reserve against deposits made by their customers (they can lend more money).

Using these tools, the Federal Reserve influences the demand for and supply of balances that depository institutions hold on deposit at Federal Reserve Banks (the key component of reserves) and thus the Federal funds rate - the rate at which depository institutions trade balances at the Federal Reserve. Changes in the Federal funds rate trigger a chain of events that effect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and prices of goods and services.

As the excess liquidity filters through the system, other types of activity increase, such as mortgage and corporate lending. Where does the government get the money to buy these securities? It prints it.

Normally the resulting lower interest rates and excess liquidity spur economic activity. But there are two components of exchange. The Fed can do much to affect the first, the supply of money which we have described above. It can do very little about the second, however, which is the velocity of money. The velocity of money is the propensity to spend the cash once it is there; it is the demand for cash. Just because there is more money doesn't mean people have to spend, lend, or invest it (these increase the velocity of money). They can save it (this does not). In order for an increase in the supply of money to have a stimulative affect, the velocity of money must stay at least constant.

This is the problem that the Fed is worrying about now and Japan has been suffering from for the last several years. There is little doubt that lower interest rates and excess liquidity has created mounds of debt. There is much doubt that it is spurring higher economic activity because the overall velocity of money has dropped commensurately with the increase in the supply. The catch is that higher debt causes the velocity of money to go down.

The Fed has little influence over people's propensity to invest or save the excess liquidity. Normally lower interest rates not only encourage people to spend more on consumption, but also to seek out alternative investments to fixed rate securities, such as stocks. As mentioned, the aggressive increase in the supply of money over the last several quarters has not had this effect to the extent necessary to stimulate satisfactory growth.

In order to affect the velocity of money, the Fed has been thinking outside the box and has suggested, through papers written by some Fed staffers, that they may employ some very unorthodox methods. The Fed knows that a higher stock market through the wealth effect may increase the velocity of money. The Financial Times reported in January that the Fed has mulled over the possibility of directly buying stocks, corporate bonds, and even real assets such as commodities. Another method suggested is a stamp tax on currency.

Sit down before you read on: This would involve a tax to hold currency. Deposit your cash at the bank, and they will charge you 1% a month to hold it!

Why has the velocity of money stalled? In my mind you can sum it up in two thoughts: high debt and over capacity.

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