99% of the time I hear someone in the media or a pundit on TV talk about the FED I want to bang my head against the wall. There is so much misinformation that gets told so many times that it seems to becomes truth to many people. The Federal Reserve (The FED), is a half private half government banking system made up of 12 regional banks. Just like any bank they have a balance sheet with assets and liabilities, have stock and interact with the rest of the banking system through lending and borrowing activities.
Now for a couple of misconceptions that drive me nuts:
The FED sets interest rates
The FED in fact does NOT set interest rates, either long or short, they are set by the market. They set a Fed funds target rate which is the intended rate for overnight lending between banks. You can not in fact borrow money at the Fed funds target rate. They will defend this target rate either by injecting liquidity (a loan) into the banking system or withdrawing liquidity by borrowing money. They lend money via short term loans (repos) usually having a duration of just a few days. When the loans expire they must be paid back to the FED, plus interest. If overnight lending rates are trending below the target rate the FED will either remove liquidity from the banking system by either not rolling over these overnight loans or doing a reverse repo and borrowing money.
When it becomes burdensome to maintain the target rate, because the demand for overnight money has either fallen or risen too strongly to be defended, the target is changed. The actual average overnight lending rate from the previous day between banks can be found at on the FED's website here.
The FED prints money
The FED does not print money, the treasury department controls the printing of money. The FED does in fact get used as a conduit for getting this printed money into the system. They do this through POMO's or Permanent Open Market Operations where they take treasuries in exchange for cash. This happens fairly rarely, and the total amount of cash added is usually $10-20 Billion a year (including this year), a fairly small amount in the whole scheme of things.
The FED is injecting tons of liquidity into the system
This is one of the biggest items I see with false reporting by the media. They will often report the amount of overnight loans made by the FED (Wow the FED injected $17 billion today) without mentioning the number of loans that expired and had to be paid back the same day. The Slosh Report is a useful tool to see what the net of all of this is. There is currently about $46B is these short term loans by the FED sloshing in the system, a drop in the bucket compared to the size of the banking system. The FED simply does not have the ability to add that much money to the system even if they wanted to because they are constrained by their balance sheet, just like any other bank.
The FED adding liquidity into the system is inflationary
Because the liquidity being added to the banking system by the FED is short term loans it is not inflationary unless the action of doing so causes the banks themselves to significantly increase lending. In fact this added liquidity can be deflationary in the long term because the interest being paid on them is going to the FED rather than staying in the system.
Really when it comes down to it the FED's biggest power is talking, trying to jawbone the market into some action. The fact that there are so many misconceptions in the media actually makes their job much easier. Words can move markets much more effectively, if everybody believes you have more power to back them up.
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Because the media knows that the public doesn't understand any of this. They're in the biz of 'mishandling' the truth, and this just makes that so much easier. Nice work laying out what the FED really is/does Matt!