Why the Fed “Has” to Cut Rates.

The Fed “has” to cut its short-term rate.  Why?  Because their current lending rate seems to create an arbitrage incentive for banks to NOT LEND.  As currently structured, the Fed’s rate policy appears to be an active drag on the economy.

The chart below shows three interest rates.

  1. The Fed’s (now 2.35%) Interest on Excess Reserves rate: “The IOER is the interest rate paid to banks for the deposits they hold with the Federal Reserve above those required by banking regulation.
  2. Market rates on 1 year (1.8%)  and 2 year (2%) Treasuries.

What if someone could borrow at the 1.8% or 2% treasury rate and put that borrowed cash to work earning that IOER 2.35%  rate?  It is only a  0.35% to 0.55% profit, but it is (literally) risk-free.  Someone can do exactly that.  Federally chartered Banks are the only entities that can make deposits at the Fed and earn that IOER.

https://fred.stlouisfed.org/graph/fredgraph.png?g=o7S0

I have NO IDEA if this is actually happening out there.  But that dynamic may be one reason why market-driven rates went into free-fall shortly after crossing over the Fed’s 2.35% IOER rate (see chart below).  A whole lot of banks exploiting a free money opportunity.  Regardless, the gap leaves the Fed exposed until they cut the IOER (which means a general rate cut).

The problem with the above is twofold.

  • Earning risk-free money at the Fed is a lot less work than the hard work of lending money to living breathing economic actors.  So the bank’s incentive is to sit back and earn deposit money at the Fed, not stimulate the economy.
  • The arbitrage profit gets BETTER as market-driven rates fall.  The selling pressure of a bank selling (imaginary) treasuries into the market would tend to push rates lower.  So the more banks sell to fund the trade, the more they will earn on the trade.  That is the really dangerous dynamic.

A caveat that this is just my thinking.  I may just be howlingly wrong on some important bit of the mechanics.  But the numbers above are real and there is clearly something broken in there.

There are any number of clever ways to sell Treasuries (that you don’t actually own) which effectively puts you on the hook to pay the interest on those Treasuries – 1 year treasuries (promising to pay 2% to the seller) or 2 year treasuries (promising to pay 1.8%).   So you sell $1b fake treasuries to someone promising to pay 1.85% (a 0.05% premium), they turn around and deposit that $1B at the Fed where it earns 2.35%.   It’s only a $500,000 profit on that $1b, but if you add a few more zeros it adds up…

And in answer to the next question – Yes, that is a hidden subsidy to the banks at the expense of the real economy and your average hard-working man on the street.  So happy you asked.

And in answer to your next question.  No, you can’t just go to the Fed and deposit YOUR money at 2.35%.  Because they don’t let little people (or even really big but non-bank-magic-circle people) step up to that deposit window.

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2 Responses to Why the Fed “Has” to Cut Rates.

  1. Dominique Watkins says:

    Man, dead on Steve.

    But wait… are you saying Trump is right ? Run screaming from the room ! LOL.

  2. Steve Kamman says:

    It depends on how you define “right.” If you mean “asking for the same thing I am asking for” then sure. If you mean “thinking logically to come to a conclusion supported by clear argument and facts” then not so much. 🙂 I am 100% confident that worries about potential long-term deflationary risks have never troubled Trump’s sleep… More practically, I worry he’s making it harder for the Fed to act by making any cut seem like a political response to Trump’s pressure.

    Appreciate the comment though 🙂

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