The Fed has hugely increased its lending against lower-quality collateral since the credit crisis broke. It has, however, sterilised the impact of this lending on the volume of cash circulating in the banking system by selling Treasury securities. This was necessary to prevent the fed funds rate from falling beneath its policy target.

The change in the composition of the Fed’s assets has raised concerns about its financial strength. Its non-conventional lending will rise significantly further as a result of the $85 billion credit facility for AIG agreed this week. Sterilising this liquidity injection via further sales of Treasuries would reduce its holdings of such securities to undesirably low levels.

The US authorities therefore yesterday announced a new “supplementary financing programme”, under which the Treasury will sell additional Treasury bills and deposit the proceeds at the Fed. This has the effect of draining liquidity from the market without reducing the Fed’s own holdings of Treasuries further.

Should the Fed follow the example of the Bank of Japan in 2001 and stop sterilising its liquidity injections? The BoJ’s policy of “quantitative easing” flooded the banking system with reserves – see chart – and is argued by some to have been instrumental in Japan’s escape from deflation.

Under current arrangements whereby the Fed does not pay interest on bank reserves, unsterilised liquidity injections would push the Fed funds rate down to zero. The Fed could, however, avoid such an outcome by paying interest on bank balances at close to the fed funds target rate, currently 2%.

The main objection to such a suggestion is that, unlike Japan in 2001, the US still faces inflationary rather than deflationary risks. Flooding the banking system with reserves would risk undermining the dollar and reigniting commodity prices. The surge in the gold price over the last 24 hours is a taster of the possible implications.