Liquidity and Interest Rates

Attention, we think, is entirely misdirected when it comes to the crucial issue of interest rates versus liquidity. This issue is NOT the FED FUNDS RATE or the FED target for FED FUNDS. This may be of significance when the situation is normal, but it IS NOW NOT EVEN REMOTELY NORMAL.

There is ONE and ONLY ONE ISSUE NOW, AND THAT ISSUE IS LIQUIDITY. Specifically, it is the LIQUIDITY POSITION OF THE BANKING SYSTEM.

There is a gross and growing shortage of liquidity in the banking system. The FED, thus far, has sat on its hands. Its liquidity injections have been followed almost immediately by MOPPING UP operations. Consequently, the DURABLE INJECTION OF LIQUIDITY HAS BEEN UTTERLY INADEQUATE. The obsession with the Funds target is dangerous nonsense.

The FED needs to inject -- ON A DURABLE BASIS -- sufficient liquidity into the banking system to allow it to overcome the deepening credit crisis. We will get an appropriate signal from the FED FUNDS market when adequate liquidity has been injected. This signal will come in the form of a stabilization of the Funds rate FOLLOWING WHAT MUST INEVITABLY BE A SUBSTANTIAL FALL. The Funds rate will naturally decline to a bottom when the rate of equilibrium between the demand for reserves and the supply of reserves are in balance. The FED'S RESPONSIBILITY IS TO SUPPLY ADEQUATE LIQUIDITY REGARDLESS OF HOW LOW THE FUNDS RATE SINKS AND TO DO SO NOW. For the FED to continue targetting a specific rate is to DANGEROUSLY SHORTCHANGE THE BANKING SYSTEM IN ITS MOMENT OIF DESPERATE NEED. Targetting equates to DRAINING DESPERATELY NEEDED LIQUIDITY. If the Funds rate falls in the morning and rises in the afternoon back to the "target" it simply REFLECTS that day's open market operations by the FED trading desk in New York -- i.e., the FED liquidity injection in the morning is removed in the afternoon.

This does not constitute even a minimal amount of MONETARY SANITY in the existing conditons, WHICH CONTINUE TO DETERIORATE THANKS TO THE FED'S FAILURE TO PROVIDE DURABLE LIQUIDITY.