Wednesday, September 17, 2008

Contrary to media reports, the Fed is not running out of money

One of the big stories today was about a special refunding that the Treasury will conduct. There will be $40 billion of short-term bills sold. The media is saying that this is necessary to give cash to the Fed. Once again the media has no understanding of monetary operations and, unfortunately, the Fed and Treasury have bad media relations departments and have not explained the situation very well. (The don’t even try.)

Over the past year the Fed, through various lending facilities, have lent out a fair amount of T-Bills. On the most recent Fed statement that covers the period through September 11, 2008, the New York Fed (which conducts monetary operations) held $7.7 billion in bills. Compare that to the same period last year, when the Fed held $96 billion in bills (system wide: $277 billion).

The Fed could, if it wanted, just buy bills held by the public. It could do a $200 or it could do a $500 billion repurchase. It doesn’t matter because it is not constrained by any, “lack of funds,” as the media likes to say.

But it is not doing this.


Because doing so would affect its target interest rate also known as the Fed funds rate. For now the Fed has decided that it wants that rate at 2% (a mistake in my opinion, it ought to be lower). If the Fed bought bills from the public, it would be adding reserves to the system and that would drive down the Fed funds target rate. The Fed would then have to just sell the bills right back to defend its target.

At the same time we know that the Fed is giving AIG an $85 billion loan. That will boost reserves by that amount and likely put downward pressure on the Fed funds rate—something the Fed does not want, at least for now. Normally, to counteract this pressure, the Fed would sell bills that it owns and recover whatever excess reserves necessary to keep the target rate at 2%. However, the Fed has only $7.7 billion worth of bills ($22 billion system-wide). So it asks the Treasury (they both work together in the maintenance of reserves) to sell the bills. The Treasury can issue as many as it wants. That drains excess reserves and helps the Fed manage its target rate.

The Fed could also sell other securities, like the $411 billion of notes or bonds that it holds, but chooses not to for whatever reason. (Could be that it would affect investor asset mix and their duration preferences.) So it asks Treasury. No big deal. The Fed is not out of money and can never be out of money because it has the authority to credit bank accounts—infinitely if it wants to.

By the way, the Federal Reserve System assets as of September 11 totaled $940 billion, and total currency in circulation was $835 billion. The Fed is well capitalized (not that that means anything) and all the currency is “backed.”

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