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Just as I had written a few days ago, it wasn’t until the Fed began locking up or calling back its inflationary programs that it would have any affect on monetary policy. However, just a few days later, the Fed has done just that, securing $200 billion worth of reserves in Treasuries in an effort to calm investors worried about inflation.

How it Works

The Federal Reserve will use reserves on hand to purchase $200 billion in Treasuries, effectively locking in the money and lowering the potential for growth in money supply and the money multiplier through a fractional reserve banking system. By decreasing the amount of lendable reserves by $200 billion, the FED has prevented as much as $2 trillion in M2-M3 inflation, though $.8-1 trillion is a more realistic number.

Lower Yields

The 56 day T-bills that are to be sold pay a far lower interest rate than the FED does on excess reserves, currently .1% compared to .25%. This effectively discourages further increases in reserves at the FED and private banks from pushing the FED towards an ever growing money multiplier.

Two Ways This Could Go

There are two different ways the Federal Reserve could go about this:

1)It could use $200 billion to buy the treasuries and hold them indefinitely, reducing the money supply circulating throughout the economy by $200 billion and thus causing a reduction in inflation.

2)The Fed could simply transfer reserves (more likely) to buy the Treasuries, creating nothing but a minor blip in the short term while drawing a definitive line in the sand in the long term.

I’ll be staying on top of this story because its sure to have a huge impact on the markets in 2010. The FED will be the game changer, and I feel safe saying it will lead the markets in 2010.

Investing