Fed Pumps Huge Wads of Cash Into System

This post appeared at 12:07 p.m. EDT today on Tony Crescenzi's RealMoney.com blog. Sign up for a free trial of RealMoney, and enjoy incisive commentary all day, every day.

The Federal Reserve announced new actions Monday to combat the credit crisis, increasing the size of its lending facility to banks and its swap facility with foreign central banks, which will deliver more dollars abroad, where demand for dollars is far more in excess of supply than it is in the U.S.

These actions will further expand the Federal Reserve's balance sheet, which, beginning Oct. 1, can expand without the U.S. Treasury having to borrow money on the Fed's behalf. Beginning Wednesday, new authority granted to the Fed in the government bailout plan will enable the Fed to pay interest on bank reserves (monies set aside at the Fed against deposits held at banks).

The paying of interest on bank reserves will enable the Fed to inject massive amounts of new money into the financial system without the injections causing an unwanted drop in the fed funds rate, essentially putting a floor underneath the funds rate (a floor is placed under the funds rate when banks place their excess monies at the Fed rather than sell the excess funds to other banks at rates lower than the rate paid by the Fed). Dollars placed in the financial system will eventually expand the money supply and help to revive economic growth.

The increase in reserves is sorely needed because the reserves that have been placed in the system have not been expanded. This is evident in recent statistics on bank credit, which has been in decline for six months, the longest such stretch in at least 40 years.

A simple rule of thumb about the impact that the Fed's injections in theory should have on bank lending is a 10-1 ratio (on the first dollar of reserves injected into the banking system, 90 cents can be lent after a deduction for reserve requirements; the next loan can be for 81 cents (90%), and so on and so forth).