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The Fed Takes Another Radical Step

by @ 12:59 pm on October 7, 2008. Filed under Credit Crisis, Economics, Politics, Sub-Prime Mortgage Crisis

In the wake of yesterday’s near-crash on Wall Street, the Federal Reserve Board has announced another radical step designed to open up a clogged credit market:

WASHINGTON — The Federal Reserve announced a radical new plan on Tuesday to jump-start the engine of the financial system.

The Fed said in a statement that it would begin to buy large amounts of short-term debt in an effort to stimulate the credit markets, which have all but dried up.

Under the program, the Fed said that it would buy the unsecured short-term debt that companies rely on to finance their day-to-day activities. “This facility should encourage investors to once again engage in term lending in the commercial paper market,” the Fed said Tuesday in a statement. “An improved commercial paper market will enhance the ability of financial intermediaries to accommodate the credit needs of businesses and households.”

While the move will put more taxpayer dollars at risk, it underscores the growing sense of urgency felt by policy makers in a climate where lending has virtually dried up. The Commercial Paper Funding Facility, “will complement the Federal Reserve’s existing credit facilities to help provide liquidity to term funding markets,” the Fed statement said.

The Fed said it is creating a new entity to buy three-month unsecured and asset-backed commercial paper directly from eligible companies. It hopes to have the program running soon.

And if you thought the $ 700 billion bailout was big, this one has the potential to be even bigger:

Fed officials said they’ll buy as much of the debt as necessary to get the market functioning again. They refused to say how much that might be, but they noted that around $1.3 trillion worth of commercial paper would qualify.

And just in case you’re wondering where that money will come from, just look at the air around you:

To pay for its burgeoning responsibilities, the Fed has no choice but to keep printing more money

Over at The Liberty Papers, Brad Warbiany lays out pretty starkly what could go wrong with the Fed’s new plan:

The current credit crunch is a largely deflationary phenomenon. Too much leverage existed in the system, and with our fractional reserve lending system, that led to too much money floating around.

The healthy way to let leverage unwind is to allow that fake wealth to evaporate. However, this is a very painful exercise. Leverage-induced inflation sends false signals to the market suggesting that natural demand for certain products (housing in this case) is increasing, and jobs and companies spring up to meet that demand. As the leverage unwinds, the money dries up, and people in those sectors are left out of a job looking for something to do.

The unhealthy way to unwind leverage is to flood the market with enough liquidity that the base of the lever expands. If you’re leveraged at 20-1, and the government steps in and loans you new capital while buying your bad assets, you can increase your capitalization and may only be levered at 10-1 while your actual holdings haven’t decreased. This is what the government is trying to do. The danger, of course, is that the new money injected into the system just adds to the leverage, and we end up in a hyperinflationary depression.

And if that happens, all bets are off.

One Response to “The Fed Takes Another Radical Step”

  1. Kevin says:

    At the rate of all these bailouts and the rate the Fed’s printing presses are running, we’re going to have to start worrying about hyperinflation in about a year or so.

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