Before I get into the actual article, I just want to say that I’m inviting everone to leave comments or questions at the end because  I am going to do my best to answer every one that’s there.

Because it’s so important for traders to have an understanding of what the Fed is doing at this time, I want to tell you about a new and relatively obscure tool being touted as a way to put a lid on inflation by controlling what some have called the “velocity” of money. What I think we’ll also be able to do is to use it as a new type of leading indicator of economic activity.

Money velocity refers to credit creation and to how quickly that credit is extended wherever it’s demanded. As you should be well aware of by this time, credit is the lifeblood of the economy; without it, the economy simply cannot function.

The tool I’m referring to is the Fed’s new ability to pay interest on the reserves that large commercial banks hold at the Federal Reserve Banks, which makes keeping excess reserves at the Fed an attractive option. Bernanke lobbied Congress to implement this last fall at the height of the panic.

Why is this so important for the Central Bank? Because in addition to giving it better control over the funds rate target it allows them to control the amount of credit going into the economy-the velocity of money.

Excess reserves now stand at about $878 billion but before the credit crisis began, commercial banks only held about $14 billion at the Fed (the amount varied slightly), which was all they were (and are) required to hold.

You might want to ask yourself where all this money came from and the answer to that is from the extraordinary liquidity provisions the Fed has provided over the past 2 years. This money represents the lending power of the large commercial banks that are holding it there. The thing is though, because of what’s known as the fractional reserve system, it really represents about $8 trillion of potential lending that’s now sitting dormant.

If that liquidity were to flow quickly into the markets it could cause a lending frenzy and a huge inflation surge. Simply put, the Fed plans to raise the rate it pays on those reserves, which in theory will motivate the commercial banks to leave a certain amount there and not lend it out as demand for credit increases.

Economists believe when the Fed begins to raise rates, it can then move more slowly to unload the considerable range of securities it has bought during the crisis. This should bring a relatively orderly unwind of all the Fed’s emergency actions.

But what it also will give them the power to do is to “take away the punchbowl” the next time the credit “party’ starts to get out of control, which is exactly what happened as the housing bubble built up. Credit actually became less expensive and more available as demand for it heated up, especially during the 2005 to 2007 period, which essentially means that monetary policy became more expansionary, the exact opposite of what should have happened.

Now, it will be important to monitor how much reserves the commercial banks are holding at the Fed, because this will directly relate to the amount of credit being created and therefore, overall economic activity. You can look at this very simply by accessing a report called the H.4.1 (Factors Affecting Reserve Balances) directly from the Fed’s website, which the Fed publishes every Thursday afternoon (EST). You can also access the report from the website of the National Bureau of Economic Research. Once you open the report, scroll down to where the Liabilities are (deposits are liabilities on bank balance sheets), then Deposits and Depository Institutions.

An exit from current Fed policy lies some time away. Even so, as the economy improves, keep an eye on that amount-the more it decreases, the more lending is occurring and the more economic activity is increasing.