The stock market is at all-time highs and the bond market is still functioning….everything is great right? Wrong. Since the current state of the markets is entirely predicated on the actions of our Federal Reserve I thought it would be a good idea to show investors what is going on behind the curtains, so to speak.
The Fed has effectively replaced the entire interbank money market and large segments of other markets with itself. It determines the interest rate by declaring what it will pay on reserve balances at the Fed without regard for the supply and demand of money. By replacing large decentralized markets with centralized control by a few government officials, the Fed is distorting incentives and interfering with price discovery with unintended economic consequences.
Did you know that the Federal Reserve is now giving money to banks, effectively circumventing the appropriations process? To pay for quantitative easing—the purchase of government debt, mortgage-backed securities, etc.—the Fed credits banks with electronic deposits that are reserve balances at the Federal Reserve. These reserve balances have exploded to $1.5 trillion from $8 billion in September 2008.
The Fed now pays 0.25% interest on reserves it holds. So the Fed is paying the banks almost $4 billion a year. If interest rates rise to 2%, and the Federal Reserve raises the rate it pays on reserves correspondingly, the payment rises to $30 billion a year. Would Congress appropriate that kind of money to give—not lend—to banks?
The Fed’s policy of keeping interest rates so low for so long means that the real rate (after accounting for inflation) is negative, thereby cutting significantly the real income of those who have saved for retirement over their lifetime.
The Consumer Financial Protection Bureau is also being financed by the Federal Reserve rather than by appropriations, severing the checks and balances needed for good government. And the Fed’s Operation Twist, buying long-term and selling short-term debt, is substituting for the Treasury’s traditional debt management.
This large expansion of reserves creates two-sided risks. If it is not unwound, the reserves could pour into the economy, causing inflation. In that event, the Fed will have effectively turned the government debt and mortgage-backed securities it purchased into money that will have an explosive impact. If reserves are unwound too quickly, banks may find it hard to adjust and pull back on loans. Unwinding would be hard to manage now, but will become ever harder the more the balance sheet rises.