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The Federal Reserves decision yesterday to purchase over 1 Trillion dollars worth of US Treasuries and other securities is akin to going all in. The fed has three basic weapons in its arsenal to tackle the monetary policy to aid and abet the fiscal policy decisions of the administration and the congress:

1) Interest Rates
2) Open Market Operations
3) Reserve Requirements

So far, the Fed has been using 1 and 2. Interest rate target is now zero. The mechanism for this is buying and selling the US treasuries until the short term rates reach is target. Essentially the Fed is adjusting the demand until the rate reaches its target. Once the target is zero, this weapon is exhausted.

Under open market operations, the Fed is basically using its power to expand its balance sheet to flood the system with money by going into the open market and buying “stuff”. By doing so, the fed is pumping money into the system. The fiscal policy just called for 1 Trillion stimulus. The Fed is accommodating that buy announcing 1 Trillion monetary stimulus. Most of this will go to the Treasury and the Treasury will issue Bonds to the Fed.

Before all this started (before September 2008), the M1 money supply was about 1 Trillion (M1 is the actual amount of dollars in circulation in the global economy and consists of physical currency (M0), checking deposits and bank reserves with the Fed). From September 08 to March 09, this doubled to 2 Trillion since the Fed pumped money into the banks (as The Chairman stated in his 60 minutes interview, the Fed simply inflated the banks’ accounts with the Fed). No actually bags of money were shipped to the banks just as no bags of money gets shipped to ones bank account when one gets his/her paycheck – this is the difference between M1 and M0 and are usually quite close.

Now the Fed has announced that it is going to buy 1 Trillion dollars worth of securities, which is adding another trillion dollars to the M1 money supply. So this effectively takes the M1 from $ 1Trillion to $3 Trillion!! Sounds ominous for the US Dollar. However, when you think about it, the world economy is about $40T (US is about $14T, 35%). Since most of the commerce is conducted in US dollar, the $40T world GDP was supported by a mere $1 Trillion of M1 money supply. Now that has/will triple to $3 Trillion and will most likely require expansion of the M0 as well (that is the actual physical dollars – printing money).

Most of the Federal deficit until now has been financed by selling US Treasuries to others (domestic and foreign entities) which brings the existing US dollars back to the US. It appears that now, the need for government borrowing has exceeded the supply of global savings hence the Fed is accommodating that need by expanding its balance sheet and increasing the money supply. The M1 supply is still (at $3 Trillion) only about 20% of US GDP and less than 10% of world GDP.

The Fed has kept a tight lid on the M1 money supply and is now opening the flood gates slowly when needed. The US dollar is the biggest asset/weapon US has. Let us hope the problem gets fixed before the weapon gets blunted due to overuse (i.e the preferred vehicle for world savings shifts away from US dollar). There is still the option 3 (reduce reserve requirements), but that might exacerbate the leverage situation, hence has not been used right now (they might be too low begin with). It will be used to take the liquidity out when economy recovers and inflation shows up.

The situation today is akin to WWII. The war and weapons are different. US went all in then; it is doing so again now….
Shaker Cherukuri
Principal
Process Improvement Solutions Inc.
3209 W. Smith Valley Road, Suite 224
Greenwood, IN 46142
317-258-3552