How does the Fed ‘mop up’ extra cash?

John W. Schoen Senior producer • Profile • E-mail

Our recent story tallying up the government’s bank bailout programs brought a bunch of fresh questions — starting with the Fed’s massive lending program pumping more than $1 trillion in fresh cash into the banking system. Just how does the Fed “drain” that money when the banking system stabilizes again?

You wrote that “once the economy starts to recover, much of the cash (the Fed has created) will have to be mopped up again. If it drains too slowly, that surplus cash could fuel inflation or another asset bubble, or both. If it drains too quickly, it could choke off growth.” …  How will the cash be "mopped up," and what does it "drain" into?
— Susan A., New Canaan, CT

The basic mechanism for adding or removing cash from the banking system is the Fed’s purchase and sale of Treasuries on the open market through the trading desk at the New York Fed. The decision to buy or sell Treasuries is made by the Federal Open Market Committee every six weeks.

If the Fed buys Treasuries, it pays cash to the banks that hold them. That cash then is available for lending, which helps increase economic activity. It also increases the supply of money in the system.

When the Fed reserves that transaction — selling Treasuries in exchange for cash — the Treasury bond goes back to the bank, and the cash paid by the bank comes out of the system. The Fed typically buys and sells with relatively short-term agreements (no more than 90 days.)

The overall level of Treasuries on the Fed’s balance sheet typically grows slowly over time, roughly reflecting the overall growth in the economy. If the supply of money doesn’t keep up with the expansion of the economy, money is “tight.” An expanding economy needs more credit to grow, a “tight” monetary policy tends to inhibit that growth. If the Fed adds money too quickly, that can cause inflation, or “Too many dollars chasing too few goods.”

When the financial panic hit in Sept. 2008, it became clear that the collapse of credit was not because the money supply was constricted. It was because lenders and investors were hoarding cash. They did so because the losses from real estate loans and investments were going bad much faster than expected, and no one knew exactly which banks were holding what assets. Banks were afraid the bank down the street might not be around tomorrow. Banks stopped lending to each other, to businesses and to consumers.

So the Fed stepped in and expanded the list of assets it would accept in exchange for cash, and the list of companies it would buy from (not just banks.) With the Fed buying these assets, some confidence was restored and more than a trillion of fresh cash began flowing through the system.

Another analogy might be water flowing through a pipe. If the pipe is clogged, it may take higher pressure to get the same amount of water flowing. The pipes are still clogged, but not quite as badly as September. Once those pipes get unclogged (banks work their way out from under their shaky loans), the Fed will need to lower the water pressure and take that extra trillion back out of the system. To do that, it will take back cash in exchange for the assets it’s been buying — commercial paper, money market assets, etc. — just as it does with Treasuries.

With so much extra cash out there and so many different types of assets, the Fed has a lot of flexibility in shoring up specific parts of the credit system. In the meantime, the Fed is carefully monitoring lending activity to see if the pipes are getting unclogged. It also has to time its moves with the overall performance of the economy and usually has to wait 6 to 9 months to see the impact of its monetary policy flow through the system. Forecasting is not an exact science; if the Fed gets it wrong it could either tighten too soon and choking off recovery, or wait too long and spark inflation or another asset bubble — or both.

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