State-sanctioned counterfeiting: the Federal Reserve's little-understood financial operations have just gotten a bit more arcane, thanks to the recent creation of the Term Auction Facility, or TAF.(ECONOMY)

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The Federal Reserve, like all central banks, is primarily engaged in manipulating the money supply. Nowadays, in the absence of any precious-metal standard tied to government money, the amount of money that central banks can create out of thin air (aptly named "fiat money") is limitless. But to conceal the reality of their operation--what amounts to state-sanctioned counterfeiting--the Federal Reserve and other central banks have developed various complex mechanisms for pumping new money into the financial system without the general public becoming wise to what they are doing.

Traditionally, the Federal Reserve has had several techniques for expanding (or contracting) the money supply (or "liquidity," in the rarefied jargon of high finance). It may, for example, change the interest rate that the Federal Reserve charges commercial banks for borrowing money--the so-called discount window. When the Fed lowers the discount-window interest rate, banks historically have been more willing to borrow money from the Fed--money that the Fed creates out of nothing. This new money, in the form of bank credit, increases the amount of liquidity, that is, the supply of money. But because borrowing via the discount window has come to be used mostly as a last resort, banks, always interested in appearing as financially sound as possible, are skittish of taking advantage of the discount window.

The Fed's most important tools for manipulating the money supply are known as open market operations (OMOs). These financial activities are carried out on every business day at the Federal Reserve Bank of New York at the behest of the manager of the System Open Market Account (SOMA). SOMA officials responsible for OMOs purchase and sell large amounts of financial instruments, by which they either create money by issuing credit or destroy money.

SOMA's portfolio consists of U.S. Treasury securities that are generally held until maturity as well as large amounts of both short-term (one-day) and long-term (14-day) repurchase agreements (repos). In a repurchase agreement, one party sells a financial instrument to a second party, and agrees to repurchase the instrument, along with interest, after an agreed-upon lapse of time. The Fed uses repos to inject money into the banking system and the economy by issuing banks cash or credit in exchange for some type of collateral. At the end of the repos' terms, the banks buy back the collateral. Because of their brief life span, one-day and 14-day repos are the Fed's primary instruments for dealing with short-term issues like market volatility and fluctuating bank reserve levels. The money created by each repo technically disappears when a repo's term ends (the repo "matures"), but the Fed issues short-term repos every business day, thereby sustaining or increasing the total money supply.

However, OMOs are transacted only by a few privileged "primary dealers," and the funds created are deposited initially in large money-center banks. Last year, when the subprime mortgage-fueled global financial crisis began to unfold, these megabanks started hoarding liquidity from open-market funds rather than lending it out. Unable to access credit and unwilling to use stigmatized ...