The Fed Moves Again

The Fed has moved with more bold action. Here are the details...

The Federal Reserve on Tuesday ramped up efforts to provide more relief to squeezed financial institutions, a coordinated action with other central banks aimed at easing a global credit crises that threatens to push the U.S. economy into its first recession since 2001.

The Fed said it will make up to $200 billion in Treasury securities available to big Wall Street investment houses and banks. The new action is designed to ensure that there is an ample supply of Treasury securities. With strains in financial markets, demand has grown for Treasury securities, considered the safest investment in the world because they are backed by the U.S. government.

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The Fed announced the creation of a new tool, called the Term Securities Lending Facility (TSLF), geared to provide primary dealers - big Wall Street investment firms and banks that trade directly with the Fed - with 28-day loans of Treasury securities, rather than overnight loans. They would pledge other securities - including federal agency residential-mortgage-backed securities, such as those of mortgage giants Fannie Mae and Freddie Mac - as collateral for the loans of Treasury securities.

Now, I am allowing for the fact that the Fed Chairman is just leagues smarter than me, but I don't really understand what this action resolves. Let's take things one at a time. By injecting the market with 200 billion dollars worth of treasury bonds, this increases the supply of bonds substantially. Everything else being equal, this would cause the yield to go down and the interest rate on the bonds to go up. That is exactly what happened today. It is unclear to me what action that causes interest rates to rise will do to help a liquidity crisis however that is exactly what the Fed has done.

The second part of the plan extends new loans and even allows for these treasury bonds to be used as collateral. Here is the rub, as Shakespeare would say. By injecting 200 billion worth of TBonds into the marketplace, Wall Street buys them up. That means that 200 billion that was in cash is now in TBonds. How does that help the liquidity crisis?

Bernanke is right in that there is extra demand these days for TBonds. I just don't understand why the Fed feels it is necessary to create more supply for this demand. This demand has contributed to lowering the rate on TBonds substantially. Isn't now the time that we want to lower interest rates? This appears to be a counter intuitive action, however, again, I allow for the fact that he is smarter than me. That said, if he is, I for one want to know what the plan here is.