Ben, all hat and no cattle, Bernanke

Open market operations affect the supply of Federal Reserve balances to depository institutions. Purchases of securities increase the quantity of Federal Reserve balances because the Federal Reserve creates the balances to pay the seller by crediting the account of the seller’s depository institution at the Federal Reserve. Conversely, sales of securities decrease the quantity of Federal Reserve balances because the Federal Reserve extinguishes balances when it debits the account of the purchaser’s depository institution at the Federal Reserve. In contrast, when financial institutions, business firms, or individuals conduct transactions among themselves, they simply redistribute existing balances held at the Federal Reserve without changing the aggregate level of those balances. Federal Reserve Bulletin

Remember when monetary policy used to work both ways? While the Fed, as famously noted by current Chairman Ben Bernanke, is more than able to create reserves and then let the multipliers do their thing, putting a lid on the money supply by withdrawing reserves seems harder. Perhaps the fact that foreign holdings of US Treasury Securities, the means by which the Fed implements monetary policy, dwarf the Fed's has something to do with the problem.

As the opening excerpt from the Fed relates, sales of securities decrease the quantity of Federal Reserve balances because the Federal Reserve extinguishes balances when it debits the account of the purchaser’s depository institution at the Federal Reserve. This only works in a closed system with the Fed as swing factor in the market.

In that closed system, Fed sales of securities not only drive the prices of those securities lower, the reduction in reserves had a multiplicative effect on credit. Thus the old adage, don't fight the Fed. So long as the Fed and its member banks had the Treasury Security market cornered, they called the shots.

But those days are gone. Now the Fed can sell those same securities into the market only to find an ever willing foreign buyer. And with the annual Trade Gap roughly equal to Federal Reserve holdings of US Treasury Securities, I don't think the Fed is in any position to bring this market back under control.

When Ben Bernanke testifies to Congress later this week, he may well, as this article from Bloomberg suggests, try to "establish his anti-inflation credibility" with his rhetoric. This will be good practice as that will be about his only tool in reality. Barring the breakdown of the current Bretton Woods II system, which could come at any time, I think the big surprise in 2006 will be the continued ability of the out of Fed control US credit system to sustain itself.

In a sense the US credit system reminds me of the Gordian Knot awaiting its Alexander.