Wednesday, March 12, 2008

Analysing the latest Fed move

The latest Fed move is fascinating. It lent $200 billion and took CDOs as collateral. Here is the logic as I understand it:

Real Real interest rates are negative. (interest rates < inflation) Paul Krugman pointed to this paper by Bernanke (PDF), which examines alternative monetary policies when interest rates hit zero.

"We also find evidence supporting the view that asset purchases in large volume
by a central bank would be able to affect the price or yield of the targeted asset."

We are not at zero on the nominal rates, but real rates are negative. The Fed basically pulled $200 billion of CDOs out of the system and injected cash, rather than simply buying bonds. This specifically targeted the problem asset class and hopefully will jumpstart the financial system machinery into gear.

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