The Fed's plans to drain liquidity from the banking system, prevent inflation

Now enters the Fed's "repos'" and "reverse repos." When the economy is bad like it is now and the banks need money to lend, the Fed buys (repos) securities from the primary dealers, thus creating a credit on the bank balance sheets, which then gives the banks more money to lend. This is what the Fed has been doing to pump money into the economy during the past year.

When the economy improves, the Fed doesn't want all this money sloshing around in the economy because it would create hyperinflation. So to drain money from the economy, the Fed does just the opposite. It sells (reverse repos) to primary dealers, forcing them to buy them and reduce their lending capacity. This has the effect of slowing the economy and preventing inflation.

The Fed has hinted that it may use reverse repos to drain money from the system when the economy picks up next year. The Fed stated that if the primary dealers are not able to handle all of the reverse repos that it would go to money market funds, which hold billions of ready dollars, for these transactions.

The other more powerful tool, of course, is to raise interest rates. Speculation has it that the Fed may raise rates sometime in the first half of next year. Right now, banks are having a field day with interest rates at 0.25%. The big banks can borrow from the Fed at this low rate and are lending it out at as much as 15% and making a killing. This has been going on since the Fed opened its "window" to allow the big banks to keep their books open for the money they are borrowing.

Do you believe that the Fed will raise interest rates next year?