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.