The Fool FAQ

Liquidity

The Fool FAQ

During the late morning each day the talking heads on CNBC give the information about whether the Fed is adding liquidity, draining liquidity, or doing nothing. I really do not have a clue as to what this means, or what effect it has on the price of Stocks, Bonds, or Big Macs. Please explain.

So often we hear about these mysterious things and seldom are they explained. So much for the WISE popular media educating you!

Okay... the Federal Reserve, as one of its responsibilities, makes sure there is enough liquidity, ie. money, in the banking system for all to transact business in an orderly fashion. This generally affects the Fed Funds rate.

Fed Funds = the "overnight bank lending rate". This is the % of annual interest that the Fed charges to banks who borrow money from them on an overnight basis. Actually, the Fed kind of frowns on any bank borrowing from them directly. They set this rate as a guide for banks to lend to one another.

When the Fed "drains" liquidity, they are going into the market and selling treasury securities. By selling bonds, they get cash in return. If the Fed is gathering up this cash, they are in effect taking it out of or draining it, from the system. So, by selling treasury securities they drain liquidity. Less money in the system means the supply is down and the demand, by default, should rise. Anytime the demand for money rises, interest rates go up. Draining liquidity is considered "tightening" monetary policy. Obviously they do something different every day, but the important thing is what they are doing the majority of the time. It may give you an idea of their plans for interest rates going forward.

When the Fed "adds to liquidity", they buy bonds from other banks. This infuses the system with cash because the banks who sell bonds to the Fed get cash in return. This potentially lowers interest rates on short term interest-bearing securities since the banks now have more more to lend. If they have more money to lend they need to attract borrowers, thus the potential for lower interest rates.