Karl Denninger
market-ticker.denninger.net
So what does The Fed actually do?
The target is indeed a lending rate – their “intended” overnight lending rate between banks. They “defend” this target by either injecting liquidity (cash) into the banking system, or withdrawing it from the banking system.
To inject “cash” they temporarily take in various debt securities (Treasuries and others) from banks, and issue them cash –
much like you’d pawn your Rolex, diamond ring or handgun.
These “repos” have a relatively short term (typically from one to 30 days) and when they expire, you are required to give The Fed back the cash, with, of course, interest.
These “TOMOs” (or “Temporary Open Market Operations”) are conducted daily in the normal course of operation of the banking system. If the actual “trading rate” of overnight money between banks is too low, The Fed will either refuse to “roll over” some of the expiring TOMOs (thereby reducing the amount of “sloshing”, or free cash, in the system) or, if necessary, will actually do a reverse TOMO, effectively “putting” some of its Treasuries (that it holds itself) out into the marketplace.
When the manipulations of this sort become overly burdensome to maintain the target rate, because the demand for overnight money has either fallen or risen too strongly to be defended, the target is changed.
That’s it.
There is also a second sort of operation called a “POMO”, or Permanent Open Market Operation. These are far more rare; they are literally outright purchases (or sales, if a reverse) of these securities.
Typically The Fed will do a handful of these per year to cover the increase in the actual demand for hard currency that accrues in the system over a year.
These are very small, usually in the neighborhood of $10 or 20 billion in total in a given year, and really ARE “printing” of money, in that The Treasury is the source of the T-bills, and when they are “permanently” taken off the market and exchanged for dollars, those dollars are, effectively, “printed”.
The Fed did not do the printing – Treasury did – The Fed was merely the conduit.
Let’s be absolutely clear here folks – “Liquidity” is not “printing money”.
It is not “inflationary”.
In addition, the actual monetary inflation conducted by injections of real, hard, CASH into the system has been miniscule all through 2007 (and prior years as well.)
Liquidity is a loan!
Let’s apply it to a typical individual’s situation and it should become clear.
Let us say that you have some diamonds, a Rolex, and a couple of handguns.
Let’s also say that you have a job, and that job pays you $5,000 a month, after taxes. You spend basically all of this, having only a few hundred dollars in the bank in cash. After all, you’re a good little consumer, right?
Now let us assume that your car has no collision or comprehensive insurance. That is, you maintain only the legally-required liability insurance.
Ok, so late one night while you are sleeping Joe Thugg shows up and steals your car. You wake up in the morning and find that your car is gone! This is, of course, a disaster. You need to get to work, or you will soon not have that $5,000 a month in income.
Well now you have a problem, don’t you?
You could go to the bank, but the bank is likely to look askance at your request for a loan. After all, you don’t have a house, and they’re not all that interested in your Rolex.
So you go down the street to the local pawn shop. Here you find “liquidity.” You execute the equivalent of a personal TOMO with the pawnshop owner. He gives you cash, and you give him your Rolex, your diamonds, and all but one of your handguns (you need the last one in case Joe Thugg shows up again!)
Note that once you walk out of the Pawn Shop you are actually in a worse financial situation than you were before! Yes, you’re “liquid”, but you now have an interest payment monkey on your back to go along with the cash.
When The Fed “injects liquidity” they have not created money; in fact, they have made the bank’s balance sheets more encumbered because the interest has to be paid too!
But of course, just like the bank, you use that $2,000 to buy yourself a car. This allows you to go to work and keep your job. A month passes, you tighten your belt, and the “TOMO” matures – you pay the Pawnshop owner back (with interest) and retrieve your Rolex, guns and diamonds.
When you hear that The Fed has injected “liquidity” into the system, this is what has happened. Further, what is almost always not reported in the media is that amount of maturing TOMOs on the same day or those bordering the action. So you will hear reported that “The Fed (or ECB) has injected a record amount of liquidity into the system” as if this is some “bullish” thing, but what they fail to mention is that the same – or even more, in many cases, TOMOs have matured on the same day, making the net injection zero!
Just remember folks – “liquidity” isn’t hard cash. It’s a loan, it carries interest, and it has to be paid back – on a short term basis.
Ok, so we’ve dispensed with this foolishness that “The Fed can save us.”
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