Gold and Energy Advisor
Gold and Energy Advisor's Real Wealth

Real Wealth #130  12/04/2007

Fed Floods US Economy with Dollars

Something important happened last week, but few people noticed.


The Fed injected money into our economy via a series of OMOs (open market operations). Added together, the OMOs represent $80.50 billion dollars flooding into our economy in just six days. A whopping $10.25 billion yesterday alone!


Even among sophisticated investors, few people pay attention to (or even understand) OMOs. But if you monitor these closely, you'll get an unmatched view of what's going on in our economy.


And the news from last week's OMO isn't pretty. 


How the Fed Injects Money into the Economy


The Fed is supposed to shepherd our economy. Ideally, we'd have a "Goldilocks" economy—not too cold (contracting in a recession), and not too hot (expanding too quickly, leading to inflation and financial bubbles).


To do this, the Fed has several monetary tools at its disposal. The main one is the federal funds rate—the interest rate at which banks lend to each other overnight. When you hear a reporter say the Fed has lowered (or raised) interest rates, this is the rate that's being described.


However, the federal funds rate is only a goal. The Fed can't dictate loan rates to banks. Instead, when the banks' rates are above the Fed's target, the Fed uses OMOs to bring them down.


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During an OMO, the Fed injects money by buying securities on the open market. These can be Treasuries, mortgage-backed securities, agency bonds, or any mixture of these.


(The Fed can sell these securities too, but this removes money from the economy. As you can guess, the Fed rarely does this.)


Buying securities is the most direct way for the Fed to inject money into our economy. As with any other sale, funds are transferred from the Fed's account to the account of the dealers who sold the securities. This increases the cash reserves of the banks which have the dealers' accounts. Thus, the banks have more money to lend.


Under normal circumstances, a bank will lend as much money as possible, to collect as much interest as possible. Therefore, the extra money flows quickly into the economy.


However, the money supply is affected even more than this. When the banks have higher reserves, they can create more money. (Fractional-reserve lending enables banks to create money from thin air, up to ten times their reserves. As their reserves increase, the money they can create increases even more.)


Therefore, for every dollar the Fed spends during an OMO, up to $10 is ultimately created by the banking system. Last and this week's $80.50 billion injection will turn into as many as $805 billion.


In other words...


Last week's injection will create up to $2,341 (out of thin air)
 for every man, woman, and child in this country!


And the inflationary effect on the dollar is obvious.


Now, if you're an avid Fed-watcher you'll notice I haven't yet discussed the temporary nature of this injection. Every OMO is either temporary, or permanent. As it turns out, the ones last week were all temporary.


In a few weeks, these transactions will expire. The dealers who sold the securities to the Fed will buy them back. Of course, this decreases their bank balances, which decreases the holding banks' reserves, which will suppress lending.


If the whole thing reverses after a couple of weeks, this doesn't sound so bad anymore. So why am I complaining about the Fed's actions? For three reasons.


First of all, the OMOs last week were extraordinary in their terms. Many OMOs will expire after only one day. Others can go longer, up to two weeks. However, the ones last week have six-week terms: that's triple the normal amount.


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Second, that's six full weeks of having $700 billion roar through our economy. That's a tremendous amount of money, with a big inflationary hit on the dollar.


The third reason is a little more complicated. I haven't yet mentioned why the Fed did these injections in the first place.


Thanks to the ongoing credit-market meltdown, banks have tightened up their lending to each other. They're still making loans to consumers and businesses, but when it comes to large financial institutions... well, these aren't doing so well. We just saw Citibank (the largest bank in the country) go begging to the Arabs for money to stay afloat. And others in trouble too.


Banks are now eyeing each other, and wondering who else is teetering on the brink of collapse. If a bank goes under, nobody wants to be that bank's creditor when it happens.


Therefore, banks are getting more reluctant to loan to each other. We see this because intra-bank interest rates are above the Fed's stated target rate. But overnight intra-bank lending is a vital part of our banking system. For example, it helps banks get through short-term cash crunches caused by delays in checks clearing.


That's why the Fed injected money all last week. Fed officials were trying to increase bank reserves, which would reduce the need of some banks to borrow, and encourage other banks to lend.


But here's why last week's OMOs are so bad for the economy. Despite this $70 billion injection, intra-bank rates have hardly budged. The Fed has been pushing on a string, it seems.


Also, the Fed's actions are addressing the symptom, not the disease. The real cause of this mess is the contagion in the financial markets, and the Fed is helpless to fix that.


As fear continues to spread throughout the markets, banks are likely to tighten up even further. Meanwhile, the Fed will use the only tool it has—more OMOs.


Fed officials have limited options here, after all. They can't force bankers to make loans. All they can do is shower dollars on their heads, hoping they'll lend some of it out.


This won't help the banks, or the markets. All it will do is inflate the dollar further.


The dollar has already been in a freefall for most of 2007. Instead of halting it, the Fed is accelerating it, and will continue to do so. This means oil prices will stay high.


And it means gold will continue its historic bull market!


Best Wishes,


James DiGeorgia


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