Some words and facts from John Hussman:<p>
"There's no question that the Fed's decision will have a market impact. This is not because Federal Reserve operations matter, but because investors believe they matter. The total amount of U.S. bank reserves affected by FOMC operations is less than $45 billion, and only the ?excess? portion of that ? typically about $2 billion dollars ? is what determines the overnight Federal Funds Rate. Meanwhile, the total amount of borrowings through the ?discount window? ? though higher than in recent years ? still amounts to only about $3 billion.<p>
There is no well defined ?monetary transmission mechanism? by which these minuscule amounts affect bank lending. Yes, during periods of crisis, the Fed has an important role to play in providing day-to-day liquidity so banks can meet depositor withdrawals. But aside from this short-term variation in the monetary base (which we saw, for example, around the ?year 2000? turn), there is not even a slight relationship between bank reserves and total bank lending. Indeed, any remnant of that relationship was wiped out in the early 1990's, when reserve requirements were removed on all bank deposits other than checking accounts.<p>
To believe that the Fed operations matter, you have to believe that a $13 trillion economy is controlled by a few billion dollars of reserves and discount window borrowings, none of which vary materially from year to year.<p>
The notion of a powerful Fed is not knowledge born of analysis, but belief born of repetition. Stop to think about how you learned that the Fed controls the economy. Not that interest rates are important (which is certainly true), but specifically, that the Fed is important. I learned it in college, from the ?money multiplier? theory that links bank reserves and bank lending (obsolete since the early 1990's when reserve requirements were largely eliminated). Some investors learn it by hearing that the Fed ?controls interest rates? and by quietly equating ?interest rates? with ?Federal Reserve.? Some investors learn it by seeing economic outcomes that follow Fed moves ?with a long and variable lag? (as one would learn that the sun rises because the rooster crows).<p>
A few notes. The Federal Funds Rate is the overnight rate at which banks lend their excess reserves to other banks. Excess reserves are typically only about $2 billion of the roughly $45 billion in total reserves. Meanwhile the Discount Rate is the interest rate on funds lent by the Fed to U.S. banks. That amount is presently about $3 billion. These are the quantities and interest rates over which Wall Street is obsessing.<p>
The Federal Reserve controls one monetary aggregate ? the U.S. monetary base, the vast majority of which represents currency in circulation. In a nutshell, the Fed buys U.S. government debt and creates ?base money? in the form of either bank reserves or currency. Of the $552.4 billion in securities purchased by the Fed since 1990 to create new base money, $546.3 billion ? about 99% ? represents currency in circulation; the pieces of paper in your pocket that have ?Federal Reserve Note? printed on top.<p>
In general, "injections" of base money by the Federal Reserve into the banking system don't stay in the banking system at all. The vast majority of base money created by the Fed is not used for new bank lending, but to provide a reasonably steady $30-50 billion a year in new currency that predictably gets drawn out of the banking system and stays there.<p>
Total U.S. bank reserves have grown by only $3.1 billion since 1990, to a total of $44.9 billion. Again, it is the day-to-day trading between banks of this amount (and actually, only of ?excess reserves? ? typically about $2 billion dollars) that determines the Federal Funds rate.<p>
The Federal Reserve lowered the ?discount rate? and opened the ?discount window? a few weeks ago. Total borrowings from the Fed have increased from about $360 million in July, to $3.2 billion currently. While some analysts have breathlessly noted that ?borrowings from the Fed have soared to the highest level in years,? the total amount of this ?fresh liquidity? is about the same as the total assets of the Strategic Growth Fund.<p>
In contrast to about $2 billion in excess reserves that is the basis for the Federal Funds Rate, and about $3 billion that is currently being lent at the Discount Rate, the U.S. banking system presently carries about $3.4 trillion in real estate loans, and $6.3 trillion in total loans. Gross domestic product is currently about $13.8 trillion.
