The U.S. Federal Reserve pumped $62 billion into the banking system over two days last week as credit fears spread and stock markets sank—a situation that’s been likened to financial Armageddon. On Thursday, the Fed injected another $17 billion. How exactly do you put cash into the market?
With huge short-term loans. The Fed auctions off these loans to the banks willing to pay the highest interest rates. For collateral, the borrowers use their government bonds and bonds and mortgage-backed securities issued by Freddie Mac, Fannie Mae, or Ginnie Mae—buying them back from the government after a period of at most two weeks. * In the meantime, the banks have more cash to lend—to each other, to corporations, to anyone who’s buying a house or car.
To initiate one of these temporary loans, the Federal Reserve Bank of New York, which handles the central bank’s transactions, posts a message on its electronic auction system. Within 15 minutes, the 21 so-called “primary dealers,” the likes of Goldman Sachs and Morgan Stanley, can submit interest rates they’re willing to pay to borrow; the highest ones are accepted. On Thursday, banks paid 4.8 percent or more in interest. The borrowers don’t actually receive the cash until a designated commercial bank—either the Bank of New York or Chase—executes the electronic transaction.
These infusions help to keep a tight leash on something called either the “overnight lending rate” or the “fed funds rate.” Banks are required by law to maintain about 10 percent of all their checking deposits in cash. *To make sure they have the right amount at the end of each day, they borrow from one another using the overnight lending rate.
If too many banks start borrowing money to cover their cash reserves, then the lenders can start charging higher interest rates. And if the rates get too high, banks will have to cover their reserves by lending less money to businesses and individuals. That slows down the whole economy. But the Fed can take action to keep the overnight lending rate steady. By injecting cash, the government makes it so that banks don’t need to borrow as much from one another—which causes the rate to drop. (The Fed can also take money out of the market to make the rate go up.)
The recent infusions were especially big, but the government pours money into the market all the time. Doesn’t all this extra cash lead to inflation? Only if the Fed starts handing out more help than the banks need—if the supply of money exceeds the demand from banks. If banks were so flush with cash that they could use the government’s loan for something else besides covering their reserves—like buying new technology or lending the money to their customers—then the cash would enter the general market, wind up in somebody’s wallet, and push up the price of goods.
Got a question about today’s news? Ask the Explainer.
Explainer thanksDavid Beim of Columbia University and John Coleman of Duke University.
Corrections, Aug. 21, 2007: The original version failed to say that banks use bonds and mortage-backed securities issued by Freddie Mac, Fannie Mae, or Ginner Mae for collateral. (Return to the corrected sentence.) It also stated incorrectly that banks are required by law to maintain 10 percent of deposits as reserves. According to the Monetary Control Act of 1980, they must hold between 8 and 14 percent of their checking (not total) deposits in reserve, as specified by the Fed. (Return to the corrected sentence.)