Is the Fed Running Out of Money?

“The Federal Reserve has requested that the Treasury Department deposit $40 billion with the central bank in an effort to help the Fed continue to stabilize the financial markets and address concerns about whether it is overstretched.”[1]

David Cho goes on to give a correct explanation of the above somewhat misleading statement. But another commentator pronounced that the money was needed to bolster the Fed’s balance sheet. Bolster the Fed’s balance sheet? The Fed prints money. It can lend any amount that it decides to without help from the Treasury. So what is going on?

For the past year banks and other financial institutions have had difficulty managing the inflow and outflow of funds through their balance sheets because their usual tools for balancing the two (liquidity management) stopped working (a slight exaggeration). An insurance company, for example, collects premiums from policy holders on a regular basis and disperses money when insurance claims are made at unpredictable irregular times. Over the long term these inflows and outflows largely balance (with a margin for operating expenses and profits). But over the short term they do not. Insurance companies invest premiums in assets that can be sold easily when they must pay claims. Carefully managing their liquidity in this way reduces the cost of providing insurance and thus lowers premium payments. This is but one type of liquidity management.

This past year many normally quite liquid assets (i.e. those that can be easily sold for cash at a reasonable price like high grade corporate bonds, treasury bills, and various collateralize securities) became illiquid (difficult to sell except at a steep discount) because markets lost confidence in the underlying value of these assets (especially mortgage back securities). It is one thing for the value of an asset to fall by a known amount (e.g. bond prices falls by well know amounts when interest rates in the market increase). It can only be sold in the market at the lower price but it remains liquid in the sense that it can be sold quickly and without difficulty at that lower price. But in current market conditions the underlying loss or potential loss in value is uncertain, making the sale of such assets much more difficult. An insurance company needing to sell assets to pay for claims arising from damage from Hurricane Ike can only do so be selling them well below their probable (but uncertain) future value. Their option of holding on to these assets and borrowing the money needed to satisfy claims is unattractive as well because borrowing from other financial firms or from the market (e.g., by issuing bonds or commercial paper) has become very expensive because firms are holding on to their cash to bolster their own liquidity or are adding larger risk premiums to lend to other financial firms.

In this environment the Federal Reserve has taken a number of steps to unblock the flow of funds in the market and to satisfy the increased demand for liquidity. Normally when the “market” needs liquidity the Fed buys treasury bills from some 25 or so primary dealers who then on lend the funds to other banks and financial firms needing it (or replenish their t-bill holdings by buying them from other sellers). When the market has too much liquidity, which pushing short term interest rates down, the Fed sells back some to the t-bills from its holdings to prevent inflation. Because of the large increase in uncertainty over the value of many financial assets and the soundness of financial firms, this “interbank” market for liquidity is not working well to spread adjustments in liquidity throughout the entire country (the Fed’s open market operations all take place in New York City). Thus the Fed has opened new lending facilities to a broader range of financial firms that can borrow directly from it in order to help the liquidity get to where it is needed. All Fed lending is collateralized so the risk of not being repaid is negligible.

The enormous amounts that the Fed is lending through these new facilities, while needed by the specific borrowers, provides more liquidity than is needed by the market as a whole given the Fed’s target for inflation. Thus the Fed reabsorbs some of it through its normal open market operations in New York (the sale of t-bills to its primary dealers in daily auctions). These operations keep the federal funds rate at the level targeted by the Federal Reserve in light of its inflation target. So the Fed is lending through one window and reabsorbing some but not all of that liquidity through another (open market sales of t-bills).

Normally the Fed can inject all the liquidity it wants to by buying t-bills or by lending through one “window” (facility) or another. It has no balance sheet limit on the amount of liquidity it can provide because as the central bank it can “print” all of the money it needs to. However, its ability to round trip (lend through one window while buying back some liquidity through another) is limited to the amount of t-bills it owns and can sell. The Fed as run out of t-bills to sell and unlike the money it can create (print) it cannot create t-bills. Some central banks in the world in this situation, issue their own bills (central bank bills).

A better solution, however, is for the Treasury to issue more of its own bills to the market than it needs for financing the government and to deposit the extra money with the central bank. Normally when the Treasury raises money by issuing t-bills and bonds, the money it receives is deposited in banks and thus remains in the private economy. Treasury borrowing of this sort does not effect bank liquidity (the money moves from the accounts of those buying the bills to the account of the Treasury. But if the money is deposited with the central bank it is taken out of the system (reduces liquidity). That money is not for the use of the central bank but rather to reduce liquidity in the market just as if the central bank sold t-bills it already owned or issued its own bills. The money deposited by the Treasury is impounded and not used just as the money collected by the Fed when it sells t-bills is impounded (it is wiped off the books). This is exactly what the U.S Treasury has just done at the request of the Fed. Its effect is identical to the liquidity reducing effect of a sale of t-bills by the Fed in a traditional “open market operation.” It does not reflect any financial weakness of the Federal Reserve. It reflects good cooperation between the Treasury and the central bank.

[1] David Cho, "Fed Asks Treasury Dept. for Funds to Backstop Intervention Efforts", The Washington Post, September 17, 2008

Author: Warren Coats

I specialize in advising central banks on monetary policy and the development of the capacity to formulate and implement monetary policy.  I joined the International Monetary Fund in 1975 from which I retired in 2003 as Assistant Director of the Monetary and Financial Systems Department. While at the IMF I led or participated in missions to the central banks of over twenty countries (including Afghanistan, Bosnia, Croatia, Egypt, Iraq, Israel, Kazakhstan, Kenya, Kosovo, Kyrgystan, Moldova, Serbia, Turkey, West Bank and Gaza Strip, and Zimbabwe) and was seconded as a visiting economist to the Board of Governors of the Federal Reserve System (1979-80), and to the World Bank's World Development Report team in 1989.  After retirement from the IMF I was a member of the Board of the Cayman Islands Monetary Authority from 2003-10 and of the editorial board of the Cayman Financial Review from 2010-2017.  Prior to joining the IMF I was Assistant Prof of Economics at UVa from 1970-75.  I am currently a fellow of Johns Hopkins Krieger School of Arts and Sciences, Institute for Applied Economics, Global Health, and the Study of Business Enterprise.  In March 2019 Central Banking Journal awarded me for my “Outstanding Contribution for Capacity Building.”  My recent books are One Currency for Bosnia: Creating the Central Bank of Bosnia and Herzegovina; My Travels in the Former Soviet Union; My Travels to Afghanistan; My Travels to Jerusalem; and My Travels to Baghdad. I have a BA in Economics from the UC Berkeley and a PhD in Economics from the University of Chicago. My dissertation committee was chaired by Milton Friedman and included Robert J. Gordon.

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