From this, we can draw a simple relationship based on the law of supply and demand. When interest rates go down, liquidity goes up. When interest rates go up, liquidity goes down.
The only problem with this is that people are not only concerned about interest rates when it comes to their willingness to save or borrow. There are all sorts of other factors that play a role too. The overall debt level, employment opportunities, salaries, etc. They all play into this. Liquidity cannot for this reason be controlled by interest rates alone.
However, in an elastic system in which cash can be conjured into existence from nothing, liquidity can be provided by a central bank through a process known as quantitative easing. The central bank prints money to buy stuff. This takes assets off the hands of sellers in exchange for cash. In this process, it is no longer interest rates that determine liquidity, but liquidity that determines interest rates. Adding liquidity sends interest rates down. Removing liquidity sends interest rates up.
During the financial crisis, the FED injected more than 1.5 trillion dollars into the economy in order to keep interest rates down. To further control the system, it established a regime of lending and borrowing between banks. If a bank has an excess of liquidity, it can park that cash at the FED over night at a very low rate. If a bank has a need for cash, it can borrow at a slightly higher interest rate.
This system has worked fine for more than ten years now. However, the extra 1.5 trillion dollars of assets on the FED balance sheets need to be wound down in order for people to keep their faith in the dollar. After all, the dollar must not be printed without limit. When extra liquidity is provided, it must subsequently be withdrawn. Otherwise, there will be no difference between the FED and the central bank in Zimbabwe or other places where liquidity is created but never withdrawn.
However, a problem has emerged. With liquidity being drained from the system, the price to borrow emergency funds has crept upwards, and is currently above the upper limit established by the FED. This is not supposed to happen and requires immediate attention. The FED must take action to stop interest rates from continuing up and out of its prescribed range.
With the extra 1.5 trillion in liquidity still out there, the FED cannot very well stop draining it, so it has decided to lower the rate at which it lends out money to banks.
The FED is now simultaneously draining liquidity from the system and setting interest rates lower, but these actions are mutually exclusive. Draining liquidity sends interest rates up. Declaring them lower will not help unless an external actor is tempted to provide liquidity. However, that actor had to be a bank, and it is the banks that are screaming for more liquidity.
It remains to be seen what happens to the system as the FED continues to drain liquidity while simultaneously declaring lower interest rates, but I suspect the reality of shrinking liquidity will trump the declaration of lower rates. If so, the FED is stuck. It will be forced to stop draining liquidity from the system. It may even be forced to provide additional liquidity in order to avoid a repeat of the financial crisis we had ten years ago.
FED headquarters
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