The first step for the US Fed is to save the banks and other financial institutions deemed too big to fail. This means their balance sheets must be strenghtened with Fed money.
THe failure of Lehman has sent a seismic shock into the world financial syatem. It is so fragile it cannot handle another one.
This is achieved by supporting existing banks and converting other failing institutions into banks - JP Morgan, Goldman and now GMAC - to allow access to the Fed discount window and importantly the Fed purchase of commercial paper for $US which are then used to buy $US treasury paper.
This achieves several objectives. Firstly, The Treasury paper is rated at 100 cents in the dollar on the bank balance sheet whereas the commercial paper is marked to market and may be say 50 cents in the dollar which would result in negative equity on the bank balance sheet and therefore a bank failure.
Secondly, the purchase of Treasury paper with Fed money provides a buyer as the Tresury raises funds for the deficit and pushes interest rates dowm.
Thirdly, it creates a carry trade for the banks an they collect the difference between the rates for the Fed money and the rates for the Treasury paper. This may be only 1% for the spread between Fed Money and Treasury but it is still some income.
Fourthly, the Fed money is sterilised in Fed reserves or Treasury paper and does not have the impact that the change in the monetary base would normally indicate.
We are still in Act 1 where the survival of the existing + new banks is the only thing that matters.
Like a WWII bomber that has lost engines and has to get back to base to survive everything is thrown out no matter how valuable it may be in ordinary times. This where we are now, unless considered critical to survival out it must go. This is defationary phase we are now in as powerful forces crash against into each other - the Fed creating $US and the collapse of financial instruments destroying them.
