Liquidity Injections

"Recently central banks have inject liquidity into the banking system. Will this create higher inflation? What is the difference between this and lowering the interest rate?" - Wallace

That's an excellent question! Normally we think of central banks controlling the short-term interest rates that major banks borrow at in order to meet their daily settlement needs. The central bank sets this rate, and then lends or borrows as required to keep the actual interest rate near the target level. In some countries, they may need to consistently inject small amounts of money into the financial system, while in others they may need to consistently remove money (effectively borrowing it) in order to achieve the target interest rate. Most of the time, the amounts of money are small.

However, once in a while there's some sort of crisis. Suddenly some banks are very short of money to meet settlement needs, and other major banks are unwilling to loan them money at the official central-bank set rate. Then interest rates in the overnight market may diverge significantly from the desired rate of the central bank.

This typically happens when there's a credit crunch of some sort. If banks are struggling with a sudden burst of bad loans, they may be reluctant to make loans of any sort, but will instead try to increase their reserves to offset the increased bad loans. Then, if the central bank really wants to maintain it's target, it needs to inject new money into the market.

To put this another way, we think of interest rates as being inversely related to the money supply. In older economic textbooks, the money supply determines demand, and therefore ultimately inflation in the economy. But the largest part of the money supply is not provided by the central bank- it is "created" by commercial banks, via the credit creation process. For each unit of money that is deposited in the banks, only a small portion is kept by banks in their reserves, with the rest being loaned out to borrowers. Thus the total amount of money in circulation is a multiple of the amount of "money" provided by the central bank.

In a credit crunch, this money creation process slows down. Banks decide that they need to keep a higher level of reserves, effectively shrinking the multiplier. The injection of reserves by the central bank is intended to offset this effect, so that the smaller multiplier times by a larger level of base money maintains the total money supply at the level that the central bank desires.

In the current case, I do not think that this will be sufficient to maintain stable inflation in the US. The credit crunch is a direct result of a dropping property market and sub-prime mortgages going bad. But there are other problems beside this. The same housing market correction will see households feeling poorer, reducing consumption demand, and therefore ultimately GDP and inflation. I expect the US to be in recession very shortly, and the Federal Reserve to start cutting interest rates significantly within a few months.

(For more information, see James Hamilton's blog here).