Does The Fed Provide Liquidity?

You may have heard people say that The Federal Reserve provides “liquidity” to the banking system. Does it really?

I will give you just a few facts about The Fed and its Open Market Operations in this article. In this limited space, I cannot answer this very complex question definitively, but I will give you a starting point to find out for yourself.

The Federal Reserve Cannot Force Banks to Create Dollars

Although the Federal Reserve can create dollars in banks’ reserve accounts, it cannot force banks to create dollars that the market can use as money.

The primary mechanism by which the Fed increases the dollar reserves in banks is through what they call open-market operations. When the Fed purchases assets in the open market, they pay for them by creating reserve dollars in member banks. Whether or not that action will create “money dollars” depends on the type of buyer of those assets.

The Federal Reserve Purchases Treasury Securities

The Federal Reserve purchases Treasury securities held by the public through a competitive bidding process. The Federal Reserve does not purchase new Treasury securities directly from the U.S. Treasury, and Federal Reserve purchases of Treasury securities from the public are not a means of financing the federal deficit. (Emphasis mine.)

Clipped from Federal Reserve Bank of New York

Primary Dealers – Federal Reserve Bank of New York

The Fed buys and sells securities only through “Primary Dealers.” The effect of these transactions on the supply of money dollars depends on whether the dealer operates as a bank or not. Purchases from banks add directly to the bank reserves, and banks decide whether to create money dollars or not. Purchases from non-banks will also add to bank reserves, but in this case, the bank must create money dollars in the dealer’s account.

The following taken directly from The Fed Bank of New York:

Primary dealers are trading counterparties of the New York Fed in its implementation of monetary policy. They are also expected to make markets for the New York Fed on behalf of its official accountholders as needed, and to bid on a pro-rata basis in all Treasury auctions at reasonably competitive prices.

I provide this list of primary dealers so you can see how many banks and non-banks:

Clipped from Federal Reserve Bank of New York

Conclusion

You can see that whether The Fed provides liquidity becomes quite a mirky question.

As with most claims about the power of The Fed, this one is overstated. If you want to decide whether or not liquidity is increasing in the market, look to the activity of banks and not that of the Federal Reserve.