What's up with the Fed?

So take a step back from panic mode and let's make a few points clear. First, it is important to understand that the U.S. Treasury and the Federal Reserve Bank (the Fed) are not the same thing. The U.S. Treasury manages the money of the U.S. Government. Hank Paulson, the Treasury Secretary, is essentially the CFO of the U.S. The Fed is a bank. A very big, unique kind of bank, but only a bank at its heart. Ben Bernanke is the president of the bank.
Aside from being the bank for the U.S. government, the Fed is the bank for other banks.  In fact, all U.S. banks over a certain size are required to deposit money ("reserves") at the Fed (hence the Federal Reserve Bank).  This is normally a percentage of their liabilities.  (For the record, Lehman and Goldman and other investment banks are not "banks", so they were not required to do this.)

It's easiest to imagine that the Fed has a bunch of individual vaults, one for each of the banks it serves.  (I like to think of the Gringott's bank from Harry Potter, with little goblins rolling carts full of money down dank subterranean passages, but you use whatever visual works for you. Alan Greenspan is, of course, really a goblin.  Look at him.)   Inside the vault for Chase Manhattan, for example, is a pile of money equal to 5% of their liabilities - let's say that is $1,000,000.

Now the Fed, much like little goblins, is kind of sneaky, and the Fed takes some of the cash out of the vault, and replaces it with treasury bonds, equal in face value.  So Chase Manhattan still has $1,000,000 in total value, but now only $500,000 is in cash, while $500,000 is in t-bonds.  BUT, the rules say that Chase has to have $1,000,000 in CASH in the vault.  Chase can borrow $500,000 in cash from another bank (and the little goblins will roll a cart full of money from one vault to another, little devils).  But if the Fed has swapped out everyones vault, then ALL the banks need more cash, and start to bid up the price of cash today.

What does that mean?  Well, how do you bid up the price of money today?  You offer higher interest rates.  In other words, the increased demand for money today raises the relative price of money today, and lowers the relative price of money in the future.  If the price of money in the future is low, then it must be that the interest rate is high.  So the Fed goblins have succeeded in raising the interest rate - this rate that the banks charge each other is called the "Fed Funds Rate", and its what the Fed decides in their meetings that you hear about.

To lower the interest rate, the Fed just performs the opposite swap.  Now they go into the vaults and replace some of the treasury bonds with cash.  Now all the banks have big piles of cash in their vaults, but many of them don't need that much cash around (because they only need cash = 5% of their liabilities).  So banks with extra cash start offering it around - there is a glut of money today, and a shortage of money for the future.  So the price of current money is low, and the price of future money is high.  If the price of future money is high, then the interest rate has to be low.  The only way banks can unload their extra cash is to offer to lend it out at really low rates.

The Fed goblins just move treasury bonds in an out of the vaults until the interest rate that banks charge each other is exactly equal to what they want it to be - the Fed Funds rate target.

Why do they do this?  Because the whole structure of different interest rates that banks charge is based off of the Fed Funds rate, to some extent.  If the Fed Funds rate is low (and the future is expensive), then the banks can get money today on the cheap, and therefore they can lend money today to YOU for a low interest rate. If the Fed Funds rate is high (and the future is cheap), then banks have to pay a lot for money today, and so they charge YOU a high interest rate.

Hence the Fed goblins influence interest rates in the whole economy just by playing with the reserve balances of the banks in the system.  It's not perfect, but it's pretty powerful.

Now why is the Fed currently having trouble?  With slowing economic activity today, the Fed would like to make the future expensive and get people to spend their money today (by lowering interest rates).  Normally this would work just fine - start replacing T-bonds with cash in the vaults.

Except that because of the uncertainty about bank balance sheets, the financial markets are scared, and so they've rushed to buy up the only safe assets around - treasury bonds.  The demand for bonds is so high that the interest rate on short run treasury bonds has gone to essentially zero.  Therefore they are jsut slips of paper guaranteed by the government, but yielding zero interest - which means they are no different than cash. So swapping out t-bonds for cash in the vaults doesn't change anything, it's just swapping one slip of paper yielding 0% for another yielding 0%, and the banks don't respond the same way they did before.

Because of this, the Fed has lost traction to move the financial markets, and we are in the position where it will take something else (like the bailout or some version of it) to get banks active again.  More on that tomorrow.