Financial Liquidity & Monetary Policy

Early in the calendar year, the Fed tends to drain liquidity from
the banking system following the holiday season. This year, for
reasons not disclosed, the Fed shrunk its balance sheet by a
whopping $400 bil. This action led to a contraction of the basic
money supply and a $150 bil. contraction in my broader measure
of credit driven liquidity. For a central bank intent on easing
credit, the tightening caper makes little sense, unless they wanted
to see how the credit markets would react to so big a change.

In any event, the Fed came along this week to announce they would
buy a little over $1 tril. of paper, including $300 bil. of Treasuries.
With this and their other facilities, the potential is there to expand
their balance sheet by $1.4 tril. or 70% to a ginormous $3.4 tril.
God bless us, that's a lot of money. Piker that I am, I would have
been satisfied if they had replaced the funds they drained and added
perhaps $100 bil. more via buying Treasuries.

So as discussed in the prior post, They are creating liquidity to
support credit growth far in excess of what the US is likely to need
over the next couple of years. Perhaps these planned purchases
will help hold Treasury yields down in the short run. We'll see.

Another gambit the Fed could have tried would have been to stop
paying interest on reserves and to start charging interest instead.
That might have served to get banks to reduce their excess reserves.

Well, we have moved much further in to a new ball game in the
annals of US monetary policy. This move has the potential to help
the economy in the short run, but it also could serve as a destabilizing
force in the long run.