As the Fed unleashed its unprecedented monetary measures – quantitative easing, ZIRP, Operation Twist, and the rest – many wondered what unintended consequences would follow. Fears of a crashing dollar, runaway inflation, and a loss of credibility proved unfounded. The Fed now says it’s mostly accomplished its goals, and it’s time to “normalize” rates.
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The trip may have seemed like a free ride, but there’s bad news: it wasn't, and won’t be. The return to normal rates will be very expensive, and borne by American taxpayers.
As The Fed Raises Interest Rates – Who Wins?
The world’s largest banks do, including many foreign institutions, like Deutsche Bank and the People’s Bank of China. At what cost? Well, maybe $50 billion or so, St. Louis Fed president James Bullard has surmised, enough to double the largest banks’ annual profits. But that now looks like an underestimate.
Shocking as all this may sound, it’s already been happening under a program called “interest on excess reserves”, a power the Fed’s picked up in 2008. “Excess reserves” are amounts that banks park safely at the Fed while looking for better ways to spend them. Back then, it was no big deal, for the amounts were tiny (less than $2 billion in 2007). But today, after all the quantitative easing, zero interest rate policies, and related magic, those same excess reserves add up to (are you ready?) 2.4 trillion dollars. So that’s the amount US on which taxpayers are now, effectively, paying interest, since what the Fed doesn’t pay out comes back to the US Treasury.
At the moment, the interest rate paid on those amounts is quite low—just .25%, so that the interest bill is “just” $10 billion or so. But here’s the rub: if the Fed is to successfully raise rates in the overall economy, it must increase the rate it pays on excess reserves first, and keep raising it in tandem with the Fed’s more general goals over time. The Fed acknowledges this on its website
Get Your Fed Speak On
If you’re not an expert in Fed-speak, the rest of this article will explain. For those not so interested in the plumbing details, just done more thing before you leave: think about how this plays out over time. Instead of today’s .25% rate (and $10 billion), do the math on more typical Fed Funds rates of 3 or 4% and see what you get. Or be conservative and just assume a rate of .75%, but stretch it out for a few years. However you’d like to tackle the issue, the bills are enormous, and won’t stop coming until those excess reserves are unwound.
For those still here: The first thing to understand is this: although you’ve probably heard that the Fed intends to “increase rates” in June or September, such headlines oversimplify the process. The Fed does not, and cannot, actually set interest rates directly -- we do still live in a free market economy, after all.
More precisely, what the Fed does is set a target for the Fed Funds rate, which is the rate at which the big banks lend to each other overnight -- the Fed itself isn’t involved in these deals. Of course, that Fed Funds rate, in turn, sets a floor underneath the rate a bank will then charge its regular customers out in the real economy for a loan, which is why the Fed is so keen to see it adjusted in response to economic conditions.
The Fed Funds Rate is Tricky
So how can the Fed announce a target for the Fed Funds rate if it can’t directly control it? Well, in normal times, it has several tools it can use to impact the amount of money that banks participating in the Fed Funds market have hanging around, available to lend to each other. For example, to lessen the spare cash standing by, the Fed might sell assets to the banks in a short-term deal called a “reverse repo.” In normal times, this would effectively reduce the banks’ cash on hand, and so push rates in the Fed Funds market up. That’s exactly what the Fed would like to do now… but it can’t.
Why? Well, historically, this whole system was pretty taught. Relatively small Fed transactions translated pretty well into rate movements, because there wasn’t so much spare cash sitting around at any of the banks. Throughout banking history, their money was lent into the real world, invested in longer-term assets, or held in required reserves as insurance that they could pay back depositors. Until 2008 and the advent of the Fed’s extraordinary measures, there were almost no “excess reserves,” idle cash sitting around in the banks hands, doing nothing.
Now we’re to the nub of the Fed’s big dilemma, for while that 2.4 trillion sits around, the market-clearing price for overnight loans between banks will stay right around zero regardless of any “target” it announces. And using standard repos to drain all that amount of excess liquidity would be like using a sump pump to clear the Mississippi.
The Fed’s Conundrum
So what are the options? The obvious one is to undo QE by selling back to the banks all the mortgage backed securities and government bonds that the Fed bought over the last many years, thus pulling all the extra cash back from their hands. But the Fed can’t do that quickly without creating utter chaos, including instantly and radically higher mortgage rates. Nope: it waded slowly into these deep waters, and it’s got to wade slowly back out.
On the flip side, the Fed could just stop paying interest on excess reserves and let rates normalize on their own. But that would take many years, maybe decades, and of course pierce the important illusion that central banks can readily manipulate rates and economies as they please – a central tenant of global stock market valuations.
So the only plausible plan is exactly the one the Fed intends to use: it will pay the banks enough on their excess reserves that they won’t be tempted to use them in the Fed Funds market and undercut the Fed’s new target rate.
Enter...The Piper Who Must Be Paid
Indeed, the only reason that the Fed Funds rate is as high as .25% today is precisely because the Fed is paying interest on excess reserves at that rate. In fact, banks can, and do, borrow US dollars at much less than .25% through the regular markets (maybe something like .1%), park the dollars in excess reserves, and so earn an utterly risk free profit. The trade is particularly attractive for foreign banks, with less burdensome regulatory capital requirements than ours; that’s why they hold half or more of today’s excess reserves.
For the banks, of course, it’s a wonderful windfall, their own version of a farm subsidy: money for holding assets out of use, and paid because otherwise markets would be flooded and prices would fall. Except here we’re talking about dollars, not alphalfa.
No doubt the Fed’s actions over the years have had an impact on asset prices, and maybe also on the jobs market. But if you worried that “what goes around comes around” or “there’s no free lunch” or “another shoe has to drop”… well, turns out that common sense holds up even in the crazy world of advanced monetary policy.