Last week, the Fed kept rates unchanged. On the other hand, growth in liquidity runs rampant. How does this happen and what does this mean? For the consumer (you and me) lines of credit, mortgages, car loans, and credit card rates stay high. We are told high rates combat the prospects for inflation by wringing excess cash and therefore demand from the economy. But there is plenty of cash sloshing around the economy. What’s going on?
The growth in M2 has been accelerating of late. Over the last quarter of 2006 it grew about 10%. The monetary base is growing increasing the reserves in the banking system. This growth fuels money-supply growth by allowing banks to grow their balance sheets (make more loans). Where does it come from and how does this happen with the Fed keeping the “rate” unchanged?
The Fed supplies liquidity to the banking system through its open market operations. These are purchases and sales to dealers (read that member banks and Wall St) of US Treasury and other debt securities. These transactions can be permanent or on a temporary basis depending on the perception as to whether the liquidity will continue to need adjustment. If the perception is that the need is short-lived, the transactions will be temporary and visa versa. An outright purchase is called a coupon pass. Temporary purchases are called repurchase agreements and are far less common.
If the monetary supply is growing the Fed must be doing a lot of purchases. But why add liquidity through coupon passes while holding the fed funds rate steady to battle inflation? Don’t get me wrong, I believe unchecked inflation is disastrous. But whose interests are these actions serving? Banks? Wall St? Hedge funds doing the yen carry trade? Is the Fed more concerned with its image as an inflation fighter than the state of the economy, holding rates steady and priming liquidity with its trading desk? Or is it worried about something it’s not telling us? Got some info, an opinion? Let me know…