The Fed’s Liquidity Confusion

The Fed’s Liquidity Confusion by Thomas L. Hogan  for AIER

The most essential function of the Federal Reserve is to provide money, or liquidity, to the financial system. The Fed is responsible for ensuring that the supply of money is equal to the total amount demanded. It is not responsible, however, for ensuring that each company and municipal government has sufficient cash to meet its obligations.

Fed Chair Jerome Powell recently testified to Congress regarding the Fed’s response to the coronavirus outbreak and lockdown. In addition to cutting interest rates to near zero, Powell described the Fed’s “forceful measures in four areas:”

1. Open market operations in financial markets

2. Programs to support short-term funding markets

3. Encouraging banks to increase lending

4. Providing credit to households, businesses, and state and local governments

The first three areas listed by Powell deal with financial market liquidity and thus lie within the territory of a prudent central bank. The fourth area does not.

The Fed’s broadest form of liquidity provision involves supplying money to the economy. The Fed attempts to influence money in the economy so that the quantity supplied is equal to that demanded for economic transactions. To help promote stability in the financial system, the Fed also supports financial market liquidity by buying and selling securities and encouraging companies to lend to one another.

A third type of liquidity, known as “balance sheet liquidity” or “asset liquidity,” has to do with the salability of bank assets. The Fed’s website describes this type of liquidity as “the cash and other assets banks have available to quickly pay bills and meet short-term business and financial obligations.” Bank deposits can be withdrawn at any time, so banks must maintain adequate cash reserves to meet these potential liquidity needs.

Bank liquidity is also important from an economic perspective. It enables lending, which allows the economy to function and grow. In addition to providing liquidity to the economy and financial markets, the Fed supports liquidity in the banking system by regulating banks’ liquid asset holdings and, when necessary, lending to banks directly.

In contrast, lending to nonbank companies does not improve liquidity in the financial system. Unlike banks, nonbank companies do not generally lend money to other companies. Hence, lending to nonbank companies does not promote credit or increase liquidity in the broader economy. For this reason, the Fed has historically refrained from lending to nonbank companies except on rare occasions when a company has direct ties to the banking system.

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