Fed injects liquidty - please explain?

[farmerEd]

Headlines today that the fed is "injecting liquidity" into the banking system...can someone please explain to me exactly what that means, and how it affects things? Injects how? to who?

Seems I should understand this more than I do...

 

[FIRE'd@51]

As I understand it, the Fed purchases securities from banks. This has the effect of injecting cash into the system. This is the way the Fed keeps (or tries to keep) the Fed Funds rate at its target, which is currently 5.25%. Due to the credit crunch we have been having in the past few days, the Fed Funds rate had actually risen to close to 6% in the market. By injecting extra reserves into the system, the Fed is trying to force the Fed Funds rate down to its target of 5.25%.

 

[TromboneAl]

Funny, I had just switched to the forum to ask that exact question.

So, let me see if I understand your answer FIRE's@51. Some G-man calls a bank, and says "Hey, we've got a ton of cash here, and we're coming over to buy an overnight "bond" from you. Now I heard that you were charging 6% for these loans, but I've got so much damn cash here, that I want you to charge me, and others, only 5.25% for this loan."

Is that about right? If not, could someone describe what happens in similar folksy terms?

Thanks,

 

[brewer12345]

The way the fed does this is they invitethe 20 odd primary treasury dealers to submit securities (treasuries, agencies, MBS) for short term repos. They accept an amount that will be sufficient to keep the fed funds rate at the target set by the Fed. The transaction is:

- dealer gives fed a security
- fed gives dealer cash
- next day they reverse the transaction to unwind

This acts as a short term secured loan from the fed to the dealer, who then goes out and loans the cash to other entities on a secured basis (repurchase agreements). The cash gets injected into the system and the fed funds rate stays where it is supposed to.

 

[JohnEyles]

The way the fed does this is they invitethe 20 odd primary treasury dealers to submit securities (treasuries, agencies, MBS) for short term repos. They accept an amount that will be sufficient to keep the fed funds rate at the target set by the Fed. The transaction is:

- dealer gives fed a security
- fed gives dealer cash
- next day they reverse the transaction to unwind

This acts as a short term secured loan from the fed to the dealer, who then goes out and loans the cash to other entities on a secured basis (repurchase agreements). The cash gets injected into the system and the fed funds rate stays where it is supposed to.

Paul Krugman, writing in the NY Times today, isn't real optimistic
about this. Although I wonder if his judgement is clouded by his
exteme pessimism about the Bush administration. On the other
hand, who can blame him - when I see Bush on TV trying to
reassure the markets, I'm like "yikes" ... THIS guy says everything
will be ok, that sure makes me feel better


And here’s the truly scary thing about liquidity crises: it’s very hard for policy makers to do anything about them.
The Fed normally responds to economic problems by cutting interest rates — and as of yesterday morning the futures markets put the probability of a rate cut by the Fed before the end of next month at almost 100 percent. It can also lend money to banks that are short of cash: yesterday the European Central Bank, the Fed’s trans-Atlantic counterpart, lent banks $130 billion, saying that it would provide unlimited cash if necessary, and the Fed pumped in $24 billion.
But when liquidity dries up, the normal tools of policy lose much of their effectiveness. Reducing the cost of money doesn’t do much for borrowers if nobody is willing to make loans. Ensuring that banks have plenty of cash doesn’t do much if the cash stays in the banks’ vaults.
There are other, more exotic things the Fed and, more important, the executive branch of the U.S. government could do to contain the crisis if the standard policies don’t work. But for a variety of reasons, not least the current administration’s record of incompetence, we’d really rather not go there.

 

[brewer12345]

I think the Fed dumping cash into the system will help a lot, especially if they do it in big amounts. I'm not sure the $39B today was enough.

If they get really concerned, they will chop rates, likely in concert with the ECB and the UK central banks.

 

[Nords]

I think the Fed dumping cash into the system will help a lot, especially if they do it in big amounts. I'm not sure the $39B today was enough.

I think most of the recent volatility has been driven by fear and overextension, aided by program trading that drives up volume in a heartbeat. Emotional overreactions like this don't come along more than once or twice a year and they can be quite profitable.

If the fundamentals were truly bad then you wouldn't see so many people diving into the muck. I'm not talking about more emotional investors but rather guys like Wilbur Ross buying into American Home Mortgage. Look at Buffett buying more railroads, and wait until his SEC filings come out 6-12 months from now. I suspect Brewer's employer has been almost as busy as Brewer himself must have been these last few weeks.

I agree that the Fed has done little of quantitative significance, but their emotional impact is huge. Bernanke has effectively said "There's nothing fundamentally wrong with the long term, but we're happy to help tide you guys over until your next payday if you want to give us a little money to do it..."

Dropping Fed rates would set a dangerous precedent-- as well as scaring everyone that, if the Fed had to drop rates then there really must be something wrong. So I'm hoping that next month the Fed says "Hey, the markets are recovering just fine, the subprime idiots got their just desserts, and inflation sure seems to be picking up-- just look at those energy prices! Sorry, folks, we can't reduce rates in the face of such employment strength and rising inflation. Carry on!"

 

[CCdaCE]

Sheesh. I sent $400 of my overtime check to Vanguard Prime today.

I'm doing my part to inject liquidity, what more does the market want? To give it to the local bank paying a paultry 1.5% instead?



-CC

 

[SecondCor521]

brewer,

It seems strange to me that the Fed left rates unchanged a few days ago but then chose to inject liquidity a few days later. Can you explain?

2Cor521

 

[lazygood4nothinbum]

i made a bloody mary the other night but i used the wrong tomato juice and so my drink came out too liquidy. it just didn't taste right, not the flavor but the texture was off. i could tell even before my first sip because the icecubes didn't suspend just right, they were bobbing around too much.

let me see if i'm starting to understand this: our economy is really just an artificial economy. our sense of value of things nothing more than an illusion.

the fed has two ways of regulating this artificial economy. it can either change interest rates i.e. the rates at which banks borrow money or it can "inject funds" i.e. print more money (with which it buys securities) which reduces the value of all pre-existing money and causes inflation.

it does this in response to investor behavior of perceived values so that each play off each other to hopefully maintain some semblance of a good bloody mary mix.

 

[brewer12345]

brewer,

It seems strange to me that the Fed left rates unchanged a few days ago but then chose to inject liquidity a few days later. Can you explain?

2Cor521

What they did today was actually normal and proper. TheyFOMC sets the target fed funds rate (5.25% at the moment). When the open market rate drops too much, they suck cash out of the system to keep the rate up. Whenthe rate goes over the target, they dump cash in to knock it down. This morning, fed funds opened at 6%, which is waaaaayyyy over the target rate. So they dumped an elephant-sized suppository into the system to drop the rate back to 5.25%.

Heck, the ECB had to dump almost $200 billion into the system to get the Euro rate back to the target.

 

[CCdaCE]

i made a bloody mary the other night but i used the wrong tomato juice and so my drink came out too liquidy. it just didn't taste right, not the flavor but the texture was off. i could tell even before my first sip because the icecubes didn't suspend just right, they were bobbing around too much.

<snip>

it does this in response to investor behavior of perceived values so that each play off each other to hopefully maintain some semblance of a good bloody mary mix.

No, you see, it sounds like you had far too little vodka.



-CC

 

[Geoffrey]

I thought the Fed's primary concern was the threat of inflation. Doesn't "injecting" a hugh slug of money into the economy tend to fuel inflation?

 

[chinaco]

I thought the Fed's primary concern was the threat of inflation. Doesn't "injecting" a hugh slug of money into the economy tend to fuel inflation?

They have many monetary concerns. Of course all of that manipulation they do can have unintended consequences. Yes they want to control inflation, but they also want economic and financial market stability.

They ride the razors edge.

 

[SecondCor521]

What they did today was actually normal and proper. TheyFOMC sets the target fed funds rate (5.25% at the moment). When the open market rate drops too much, they suck cash out of the system to keep the rate up. Whenthe rate goes over the target, they dump cash in to knock it down. This morning, fed funds opened at 6%, which is waaaaayyyy over the target rate. So they dumped an elephant-sized suppository into the system to drop the rate back to 5.25%.

Heck, the ECB had to dump almost $200 billion into the system to get the Euro rate back to the target.

I understand now. Thank you for the reply.

2Cor521

 

[FIRE'd@51]

I thought the Fed's primary concern was the threat of inflation. Doesn't "injecting" a hugh slug of money into the economy tend to fuel inflation?

Remember, this is a short term injection of cash which will eventually be taken back out, so it won't be inflationary in and of itself. The Fed does this all the time (in either direction) as the Fed Funds rate drifts away from its target. This recent injection was larger than usual because the Fed Funds rate had drifted far away from its target (6% vs 5.25%).