The Fed influences the economy and markets by setting official rates and expanding or contracting its own balance sheet. Attention tends to focus on the former but balance sheet trends sometimes convey important additional information.

While the Fed slashed official rates in late 2007 and early 2008, Federal Reserve Bank credit – a key balance sheet measure – contracted. This suggested policy was not sufficiently expansionary to offset deteriorating economic and market trends.

The Bear Stearns crisis has forced the Fed to inject more cash – Fed credit jumped by $10 billion in the week to last Wednesday. An additional $20 billion was lent under the Term Auction Facility, $13 billion under the new Primary Dealer Credit Facility and $6 billion in connection with the J P Morgan-Bear Stearns transaction. The Fed partially offset these injections by selling $32 billion of securities from its own portfolio.

These changes have pushed the three-month growth rate of Fed credit to its highest since November – see chart. The Fed could yet sterilise recent and future cash injections, returning the balance sheet to its prior path. However, a continuation of the recent pick-up would be a strongly positive signal for economic and market prospects later in 2008.