Liquidity Situation

As we rolled into September, the liquidity situation was still on the
tight side. My proxy for credit driven liquidity is up by only 3%
yr / yr. This is too small an increase to fund economic expansion.
Monetary liquidity via Federal Reserve Bank Credit was up only
about 4% over the same period. Low liquidity growth reflects
the economic downturn, bank reticence to lend, and a still rather
conservative policy of lquidity injection by the Fed. If you deflate
the changes to liquidity by a roughly 5% inflation rate, the tightness
in the system is all the more noteworthy.

With Lehman in Ch. 11, it will likely have to liquidate a sizable
portion if not all $600 plus billion of its asset book. A goodly amount
of the book will present no problems, but there will be significant
difficulties with the subprime and other "toxic" paper it holds. As
well, Lehman may have to stop funding its pet SIVs and other
conduits. In recognition, the Fed cobbled together a pool of funds
from the 10 major banks of $70 bil. and added $70 billion itself via
the repo market today to provide liquidity to unwind the Lehman
book and those of its debtors. But this is all temporary and does
not constitute a departure in policy. There is also a scramble to
provide short term funding for AIG, the huge insurer, which needs
to raise capital. Since the Fed and Treasury now have to manage
a large portion of junky paper on their books via bailout, they may
have rejected a Lehman survival guarantee to preserve
remaining integrity in an uncertain environment.

The Fed is now skating on very thin ice regarding its liquidity
policy. Weakness in retail sales, rising business inventories and
falling production point to a deepening of economic difficulty, and
the Fed probably should step up liquidity infusion moderately
to avoid prolonging the downturn. The commodities driven
inflation fever has broken for now, so the Fed may have a
"window" to add some $ dough to the system.