On Tuesday the Fed announced it was increasing the interest rate it pays on bank's excess reserves to 1%, equal to the Federal Funds target rate. Dr. James Hamilton, who runs the very educational/helpful Econbrowser blog had a great post last month on why the Fed is encouraging banks to lend to the Fed instead of, say, each other or other entities. This fit nicely into our textbook material today, which allowed me to share it (although I spent a long time making sure I understood it well enough to teach it).
The Fed's balance sheet is expanding, it's projected to be $3 trillion very soon (it was only $800 billion a year ago). This is beginning to draw some attention.
The Fed is making huge emergency loans to AIG, buying up commercial paper, acquiring a lot of assets. It doesn't have the means to do that like it wants on its own, so it is having Treasury supply it with cash via the sale of new Treasury securities, and banks increasing their reserves (ie: lending to the Fed).
The fact that they're raising the interest rate paid to banks in order to provide even more incentive to lend money to the Fed means that the Fed needs even more money to buy even more assets. $2 trillion hasn't been enough! (Note: I was wrong in my post yesterday about why the Fed wants banks to hold excess reserves).
(Geek note: I spent a good 15 minutes giving my class my bogus info [didn't know it at the time] from the aforementioned Econbrowser page on why there wasn't an arbitrage opportunity for banks to borrow at .27% from GSEs and then lend to the Fed at a 1% rate. One heartening thing for me is that PhD economists are trying to figure out why the no-arbitrage assumption doesn't apply to the Fed funds market right now. Oh well).
In a slightly related note, I saw Treasury Secretary Henry Paulson on NewsHour tonight and was a little disgusted. (Jim Lehrer was a poor choice for an interviewer, he knows nothing about finance/economics). He talked out of both sides of his mouth. Would have been nice if he'd said:
"You know, we knew there was a big problem but we didn't know how to handle it correctly. We thought buying troubled assets was the way to go, but later listened to economists who said we weren't thinking it through well enough. They were right. We're making this up as we go."
Instead it was: "We should have passed the TARP sooner. Things are better now than they would have been. Everything is under control, except the general economy. That's a mess that we can't fix. I never said I could fix that mess, but maybe I'm a bad communicator. We've addressed the housing issue by not really addressing it. It will bottom out sometime, and until then we're in a mess. Oops, I didn't say that either."
There's this assumption that he knows what he's doing. So far, doesn't look like it.