The Generalist

Fed Buying Treasuries

Cryptogon is an excellent news site which I highly recommend to anyone who would like his news pre-filtered for importance. In a recent post Cryptogon expresses surprise that the Fed might start buying treasuries. In fact, most of us have been wondering why the Fed HASN’T been buying treasuries, since, in fact, this is what the Fed does (buy treasuries in the open market) to implement monetary policy (i.e., inflate). Of course, inflating right now is not actually a good idea. Nevertheless, Helicopter Ben has made it seem that this is exactly what he would do to prevent a stock market crash and depression and well… so far he hasn’t done it. Maybe he’s smarter than he lets on.  (Why inflating right now is not a good idea is actually a bit complicated, I’ll try to come back to that in a follow-up post.)

You can see what treasuries the Federal Reserve currently holds by looking at the SOMA. All of the Feds holdings are here. (It is interesting that it’s called soma, which is the also the name of the happy pill from Brave New World! How Keynesian!).

Many people are also wondering why the dollar has been getting stronger. The banking system is a fractional reserve system. This means that the banks can pyramid loans on only 10% held in reserve, i.e., they can loan out 10 times what they actually have in deposits from people like you and me. When the Fed buys treasuries in the open market, they are adding to the banks’ reserves. However, if people like you and me take our money out of the bank and hold it in cash instead, we are subtracting from the banks’ reserves.  Either way, banks can “pull in” loans or stop lending. If they do this the money supply shrinks by the amount of the expansion. As the money supply falls, so do prices. Hence, the falling stock market (and gold!) and the rising dollar. 

The quest for “liquidity” is related to this. When highly leveraged players (i.e., players who have used big loans to buy stocks) are asked to repay their loans, they have to sell their stocks to do it. The more they sell the more prices drop tripping the next round of repayment requests and so on.  The banks do not renew these loans or else individuals who would take loans to buy stocks remain on the sidelines waiting for the prices to fall further… and the credit contraction continues.

This is a fairly simplistic explanation of what is going on, but I think it will help you understand it conceptually and maybe understand the news a little better. When you hear the Fed is considering buying treasuries, you will now know that they are thinking of increasing bank reserves. I am currently working on an explanation of inflation and deflation for my new series “The Basics” and I hope to have that up for you soon. That article will go into detail about what inflation and deflation actually are. Stay tuned and by all means post any questions you have and I will do my best to answer them.

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