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The Federal Reserve is our nation's central bank. It, unlike other central banks of the world, is a body independent from our government (although its board members and chairman are appointed by the President and ratified by Congress). With its establishment in 1913 it has a mandate to promote price stability, full employment, low interest rates; as well as regulate the commercial banking sector.

Its tools take the form of monetary policy actions, not fiscal policy actions. In other words, it can influence interest rates and the money supply. But it can't spend and raise revenue through issuing debt or levying taxes. Only Congress and the President through the Treasury can perform those latter.

The Fed's most commonly used tool has been traditionally influencing higher ("tightening") or lower ("easing") the interest rate banks pay to borrow funds. Raising those rates chills bank lending activity, if the Fed fears that the economy may overheat and cause inflation. Lowering those rates tends to spur lending activity, if it has slowed from fear of recession.

That's worked pretty well for most of the past century. Until recently. Commencing in 2007, when it became abundantly clear that we were heading into a severe and unprecedented credit crunch, the Fed began lowering rates toward an unheard of (just pretend Japan doesn't exist) zero percent. It has since held rates near zero for almost four years now, and yesterday indicated that it will continue to do so until at least mid-2015.

In essence, the Fed has indicated that it will keep the cost of borrowing funds for banks free, for the better part of a decade. Most easing cycles of the post-World War II period lasted for a handful of months to maybe a year-and-a-half. Typically, our current unprecedented level and duration of low interest rates would have caused the economy, and likely inflation, to explode long before four or seven years had passed.

But that hasn't happened. Growth is weak. Jobs are recovering at the worst rate since the Great Depression. And broader indications of consumer inflation indicate that it has been hovering in a very benign zone of ~1.5-2.5%.

The reason that hasn't happened is because we are suffering the deflationary effects of a depression - what the Fed is trying to avert. The cost of stuff we buy might not have declined yet by virtue of the Fed's monetary stimulus to-date, but deflation nonetheless is finding ways into the system in the form of declines in wages, for instance.

A depression is different than your typical recession. Recessions are caused by the natural ebb and flow of the business cycle. Depressions are protracted and deeper than typical recessions, caused by a long period of society-wide debt pay down after an over-expansion of easy credit and leverage.

They simply take a real long time to work out. And there isn't much anyone can do about it. But the Fed keeps trying, as the lack of any political fortitude has neutered any further fiscal action. On top of years-long zero interest rates, the Fed has also been making outright purchases of securities in the market place. This is its so-called "quantitative easing" ("QE").

So what does that do? In essence, it places cash directly in the hands of financial institutions. In its conventional easing process of lowering short-term interest rates, the Fed literally purchases treasury securities with very short maturities from banks and other financial institutions. The Fed is bigger than that market (as it has unlimited purchasing power, ultimately backed by the Treasury that can print money), so its actions influence market interest rates lower.

But once it pushes rates to zero as it has, that policy becomes ineffective - the so called "liquidity trap." So that's when it resorts to the unconventional QE. With QE operations, the Fed purchases treasuries with longer dated maturities for cash. This is more potentially inflationary than its conventional method of easing for a couple reasons.

Firstly, in the conventional method, it doesn't really buy those very short-term securities for cash. It purchases them in exchange for a "reserve credit" that the bank can put on its balance sheet. Think of it as a casino chip - it has value to the casino (to the Fed, that requires banks to keep a certain amount of funds relative to deposits), but no value outside of the casino.

Until the bank actually "cashes in" that credit and uses it to make a loan to someone who wants one, the Fed has not issued cash into the money supply. And in case you haven't noticed, banks haven't been exactly tripping over themselves to make loans nowadays.

QE is different. It is a direct purchase for cash of securities by the Fed, with money (at this point) literally printed out of thin air by the Treasury. It immediately and directly expands the money supply. And since it is purchasing securities that don't mature for years - where in conventional easing it typically purchased securities that mature in days - it effectively expands that money supply for years longer than standard easing might.

Further, the Fed isn't just buying treasuries (notes issued by the Federal government to borrow money). But let's just look at that for a second. Through QE, the Fed is borrowing money printed out of thin air from the Treasury… to buy notes issued by the Treasury to borrow money. In other words, through the Fed (as independent as it may be) our government is lending money to itself and in that process just printing money to keep the whole nation from collapsing into a deflationary spiral. Nice.

So it is not just buying treasuries, as I said. It is also buying mortgage-related securities. Remember those things? That caused the financial crisis? The Fed's buying them because no one else wants to.

Which brings me to my point. I have maintained for three or four years now that the financial crisis never really ended; that the crisis has just moved to different quarters; that the threat and risks are still with us, just manifested in a different manner.

Today, those risks of using excessive leverage to invest heavily in risky assets are being moved off of the private sector's balance sheets and onto the Fed's balance sheet (as well the Federal government's as weak economic activity increases its debts from lack of adequate revenue collection). Pre-crisis, say late-2006, the Fed's balance sheet was roughly $900 billion of assets and liabilities (the Fed typically maintains a "matched book," where assets equal liabilities).

At year-end 2006, the Fed's liabilities were mostly our checkable deposits, $779 billion (a good chunk of the money supply). Its assets were mostly treasury securities, $741 billion.

Moving forward to today (latest report is through March 31,2012), the Fed's balance sheet is over triple what it was - now $2.9 trillion. It's never been expanded anywhere near this size before in its century-long history. Its liabilities are now about $1.1 trillion of our deposits, and now $1.5 trillion in member bank reserve credits.

So with about $2 trillion of quantified Fed activity geared toward stimulating the economy, it has increased our deposits by a mere ~$300 billion. In essence, ~15% effectiveness, if you will.

The rest of that "stimulus" - the $1.5 trillion of reserve credits (which was a scant $19 billion in 2006) - sits on bank balance sheets across the land not being lent, even though those funds for lending come free for the banks. Which is why the Fed moved on to QE. If the banks won't use the funds to expand the money supply, the Fed will just eliminate that "middle man" and do it directly by purchasing securities outright. So now it owns $1.7 trillion treasuries (up from $741 billion) and… nearly $1 trillion in mortgage-related securities issued by… the now since failed and nationalized Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC). Because no one else wants to touch that stuff.

So when our Fed embarks on an experiment, never before attempted to this scale, and triples the size of its balance sheet, taking on $1 trillion of instruments no one else wants (that it owned $0 of in 2006 and before because it wasn't allowed to), it might cause one to regard with concern the financial health of our central bank.

And yesterday, because all this activity has produced paltry results at best, the Fed announced that it is further going to buy another $40 billion of that stuff, each month, going forward into oblivion. With money that we are creating out of thin air.

The crisis is still here. But instead of destroying home prices, Countrywide, Fannie Mae, Freddie Mac, AIG, Bear Stearns, Lehman Brothers, Merrill Lynch, Washington Mutual, Wachovia, IndyMac, GM, Chrysler and the European PIIGS… now it merely threatens to destroy our central bank, the dollar and with that our full faith and credit.

Oh yeah. And then we have that "fiscal cliff" coming up in a few months too. That's a whole 'nother story.

Have a nice weekend.

Source: The Frightening Reserve