About 15 minutes after my last post, stocks mounted a roaring comeback, reversing about half their losses. I'm not sure why, but I've learned to never underestimate the power of the Fed. They have been hard at work reliquifying the banking system, and the surge in reserves I noted awhile back was the first sign that they were gaining traction. The decline in short-term swap rates was another sign.
As of today the Fed starts paying interest on the reserves that banks hold at the Fed. That makes it easier for the Fed to expand the money supply. Why? Because in the past if they added reserves to the system by buying other assets, they would have to take offsetting action to drain reserves in order to keep the funds rate at their target. If they added too much money then the interest rate on reserves would fall, because, since banks don't earn interest on their reserves it's equivalent to a tax, or opportunity cost, they would dump any excess reserves back into the market, depressing the funds rate, and requiring the Fed to soak them up. Now that won't be a problem (well, it will actually be less of a problem, since the Fed may not pay the same rate on reserves—probably less—as the rate of their Federal funds target).
So now they can pump in reserves easier, and extra reserves will go a long way to assuaging fears of bank failures. Eventually those reserves can translate into more money for the economy, and that's apparently just what the economy wants and needs at this point. We'll worry about the inflation implications of this later. But for the time being I wouldn't get caught up in the popular notion that our biggest threat here is one of deflation.