Monday, October 6, 2008

Fed Paying Interest on Reserves, Increasing TAF, Jumping Through Hoops

The Fed has released a statement announcing significant efforts to boost liquidity in the credit markets.  The Fed will begin to pay interest on required reserve balances and excess reserve balances.  Additionally, the Fed will increase the amount outstanding in the Term Auction Facility (TAF) to a potential amount of $900 billion over year end.  The TAF auctions 28-day and 84-day loans to dealers in return for collateral accepted by the discount window (which currently includes all sort of questionable securities and possibly old shoes.)  The increase in the TAF is meant to alleviate strains in the term market for funds.  Apparently, banks are terrified of lending to each other for more than a few days because of counterparty credit risk fears.  The Fed is the only counterparty that is guaranteed to be around in a few months.  

While I do believe that these actions appear necessary to keep more banks from failing, I still find them extremely disturbing.  The Fed is propping up our banking sector.  How much longer will it work, and what happens if it fails to prevent more banking collapses?  If you thought the $700 billion bailout plan was big, how do you feel about the $900 billion TAF?  Or the $400 billion in "other loans" sitting on the Fed's balance sheet?  While the amount of assets on the Fed's balance sheet continues to increase, it is wise to remain cautious.  I'll be checking in with the Fed every Thursday afternoon for an update on its balance sheet as a decrease in assets will be a crucial indicator of when the worst really is over. 

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