fluidity concerns

In order to prop up the balance sheets of banks and inject liquidity into the system, FED is now buying mortgage backed securities and commercial paper from the market. During these operations it is literally printing money and crediting the excess reserves of the recipient banks. Hence the explosion of excess reserves to previously unimaginable levels:

What are the banks doing with all the cash? They are just sitting on it. Excess reserves are not withdrawn from FED. Otherwise we would have seen a significant jump in "currency in circulation":

The balance sheets of banks have improved but the system remains fragile. True, the interbank lending rates (such as LIBOR) have gone down. However, due to the explicit guarantees extended by the governments, these rates no longer reflect the true health of the financial system. The interbank lending market is now on medication.

The banks are still hesitant about extending loans to non-financial companies amid the continuously deteriorating economic conditions. FED can expand the monetary base as much as it desires to. But if banks refuse to create money by making loans, then the money supply will not increase:

Even if banks turn on the tap, the money will not flow as fluidly as it used to. Say a bank gives out a commercial loan and the receiving company makes a purchase. The new holders of the cash will either sit on it or use it to pay down debt. Either way the money will immediately flow back into the hands of risk-averse banks. The pipe is clogged. It does not matter whether you turn on the tap or not.

The extremely uncertain economic environment makes every CEO tremble with fear. The time horizon of supply chains has collapsed. Purchasing managers buy material only on spot and only when needed. None of them are willing to commit to long-term contracts. Most of the previous long-term contracts has been unilaterally cancelled and the number of litigations has sky rocketed.

Postscript 1:

Banks lend their excess reserves in the overnight market to those institutions whose reserves are below the legally required level. The prevailing interest rate in this market is called the FED funds rate. FED conducts its monetary policy by setting a target FED funds rate and by trying to push the market towards this target via open market operations. Up until September FED was able to achieve this. Then it lost control:

The exploding excess reserves put downward pressure on the FED funds rate. The interest rates hit zero and consequently the overnight money markets froze. FED wanted to maintain a low interest rate but did not want to kill the money markets which play a principal role in supplying short-term credit to the banking system. Moreover FED funds rate had become dangerously jittery. In this context FED had three main goals: To contain the volatility of FED funds rate in order to provide some certainty to the unstable markets / To keep FED funds rate low and hope that this will stimulate the real economy despite the broken banking system /To create a non-zero floor under FED funds rate to ensure the survival of money markets.

In order to attain these goals, FED cut its target rate to a range of 0% to 0.25% and declared that it will pay 0.25% interest rate on all reserves and excess reserves. (Note that, during normal times, excess reserves earn the FED funds rate and reserves kept at FED earn no interest at all.) This is another reason why banks are sitting on excess reserves and not withdrawing them from FED. On a risk-adjusted basis, FED's 0.25% is perceived as the best over-night interest rate in the market. For comparison, note that even the 3-month treasury bills (backed by the full faith and credit of US government) currently yield less than 0.25%. What about commercial paper, corporate bonds and etc.? Banks simply do not have the risk appetite to touch those.

Postscript 2:

One of the reasons why asset prices are so depressed at the moment is due to the massive deleveraging that is taking place. When banks call back loans, companies can do three things: Pay cash / Refinance / Sell non-cash assets. Refinancing is impossible for anyone but those who do not need it. Cash is extremely hard to find since consumers have cut back on spending and companies have shelved their investment projects. So there is only one option left. The companies will have to liquidate their inventories and sell parts of their businesses. However if every single company in the economy does the same thing, the value of these inventories and businesses will simply collapse. Why? Because there will be no buyer side! All balance sheets can not shrink at the same time. If one balance sheet shrinks, somewhere another balance sheet needs to expand. Fortunately there is one candidate that can technically absorb everything: FED's balance sheet.

Think of the FED & Treasury couple as the only trustworthy bank left in town. Investors are willing to buy 1-Month Treasury bills at 0% interest rate and banks are happy with the 0.25% interest rate paid on their excess reserve accounts. Hence, in case nobody wants to buy commercial papers or mortgage backed securities, FED can easily step in by borrowing from US Treasury through the Supplementary Financing Program, or by spending the excess reserves provided by the banks.

If banks at some point decide to withdraw their excess reserves, FED can either relabel the withdrawn amount as "currency in circulation" or sell some of its assets. If there is a worry about inflation, then FED will choose the latter option which effectively sterilizes the cash supplied to banks by draining money from the them through asset sales.