Banking system is flooded with money

Since mid-September the Federal Reserve has been moving toward a new policy called quantitative easing, or commonly called "printing money”, which essentially pumps enormous amounts of funds to the banking system beyond what the system need. The policy is intended to stabilize the markets, maintain the Fed's interest rate target, and affect the rates on other types of credit. The ultimate goal is to support financial markets and revive the economy.

As a result, the excess reserves in banking system exploded to unprecedented amount. The challenge is that the banking system is still reluctant to lend under the current condition. While the policy didn’t work well in Japan from 2001 – 06, it comes with risk of sparking inflation.

Here is what BusinessWeek said about the policy.

… Until the Sept. 15 bankruptcy of Lehman Brothers, excess reserves, or those funds available for trading between banks in the overnight markets, had typically averaged about $2 billion a week. Since then they have exploded to an unprecedented $605 billion a week on Nov. 19. As a result, interbank funds are already trading well below the Fed's 1% target rate. That means actual policy is even looser than the target rate indicates…

… The Fed's Nov. 25 decision to begin buying up to $600 billion in mortgage debt and mortgage-backed securities from Fannie Mae (FNM), Freddie Mac (FRE), and the Federal Home Loan Banks is the biggest step yet in this new strategy…

… This program, plus the Fed's plan to lend up to $200 billion to holders of securities backed by credit-card debt, auto loans, and small business loans should breathe some life into the moribund securitization process that is so crucial to the flow of credit.

… Japan's experience showed the strategy did little to boost lending. Right now in the U.S. there is little desire to lend or borrow. There's also the long-term risk that flooding the system with money will spark inflation.