Federal Reserve Bank credit – the Fed’s aggregate lending to the banking system – rose by an unprecedented $219 billion, or 22%, in the week to last Wednesday. This reflected increases in currency swaps with other central banks, lending to banks to finance purchases of asset-backed commercial paper, primary dealer and other broker-dealer credit and the AIG loan.

The annual growth rate of Fed credit is now 32%, exceeding the levels reached at end-1999, when the Y2K computer scare led to a precautionary dash for cash, and after the 911 terrorist attacks, which temporarily disrupted the payments system – see first chart.

A key issue is whether the Fed will fully sterilise the impact of its increased lending on the monetary base (i.e. currency in circulation and bank reserves held with the Fed) – failure to do so would amount to “printing money”. As the chart shows, monetary base growth also rose sharply last week but this may reflect the technical difficulty of sterilising such a large injection immediately.

The short-term rise in bank reserves has pushed the actual level of the Fed funds rate well below the 2% target – see second chart. This amounts to an effective easing of policy, albeit possibly temporary.

While the jury is out, I doubt the Fed is yet ready to embark on an explicit policy of expanding the monetary base. Unlike Japan before its adoption of “quantitative easing” in 2001, the US still faces inflationary rather than deflationary risks. Flooding the banking system with reserves would risk a collapse in the dollar and a sharp rise in Treasury yields, exacerbating current financial difficulties.