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The Fed, liquidity, and credit allocation

  • Daniel L. Thornton

The current financial turmoil has generated considerable discussion of liquidity. Moreover, it has been widely reported that the Federal Reserve played a major role in supplying liquidity to financial markets during this distressed time. This article describes two ways in which the Fed has supplied liquidity since late 2007. The first is traditional: The Fed supplies liquidity by providing credit through open market operations and by lending to depository institutions at the so-called discount window. The second is by enhancing the liquidity of portfolios of some institutions by replacing their less-liquid assets with more-liquid assets. The Fed has used the second approach since late 2007. Unlike several previous occasions, however, it began supplying liquidity in the first, more traditional way only recently-in September 2008. This article notes that the Fed departed from its long-standing tradition of minimizing its effect on the allocation of credit by supplying liquidity to institutions that it believed to be most in need; at the same time, it neutralized the effects of these actions on the total supply of liquidity in the financial market. The article also discusses the Fed's reasons for reallocating credit this time rather than simply increasing the total supply of financial market liquidity.

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Article provided by Federal Reserve Bank of St. Louis in its journal Review.

Volume (Year): (2009)
Issue (Month): Jan ()
Pages: 13-22

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Handle: RePEc:fip:fedlrv:y:2009:i:jan:p:13-22:n:v.91no.1
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  1. Daniel L. Thornton, 1998. "The Federal Reserve's operating procedure, nonborrowed reserves, borrowed reserves and the liquidity effect," Working Papers 1998-009, Federal Reserve Bank of St. Louis.
  2. Christopher J. Neely, 2004. "The Federal Reserve responds to crises: September 11th was not the first," Review, Federal Reserve Bank of St. Louis, issue Mar, pages 27-42.
  3. John B. Taylor & John C. Williams, 2008. "A Black Swan in the Money Market," NBER Working Papers 13943, National Bureau of Economic Research, Inc.
  4. Todd Keister & Antoine Martin & James J. McAndrews, 2008. "Divorcing money from monetary policy," Economic Policy Review, Federal Reserve Bank of New York, issue Sep, pages 41-56.
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