What Does the Federal Reserve Not Understand?

It is really hard to resist taking potshots at the Federal Reserve; they present such a large, slow-moving target. Everyone from the German Finance Minister to various commentators and money managers are making fun of Bernanke, who responds with a daily attempt to explain himself in op-ed pieces or speeches.

One of the less obvious consequences of the Fed’s policy to keep short-term interest rates at zero is the possibility for virtually risk free profits for banks (i.e. another bank bailout). Banks can borrow from the Federal Reserve essentially for free. The Fed hopes that banks will then lend out this money to businesses and consumers, which would stimulate the economy by …. blah, blah… We have all heard this argument too many times.

However, the banks show no inclination to lend to businesses and consumers, and potential borrowers show little inclination to borrow. Household debt declined 0.9% over the last quarter. Outstanding commercial loans are down about $70 billion since the beginning of the year. This is a natural reaction to getting burned in a credit crisis and it will continue until greed overtakes fear again.

So, in the meantime, Banks happily borrow from the Federal Reserve for free and lend the money back to the Treasury by buying US Government bonds. Bank purchases of US bonds rose from $47 billion in the first half to $127 billion in the second half (link). The banks pocket the income from the bonds as almost risk-free profit. Something very similar has been going on in Japan for decades (debt article).

The Fed’s quantitative easing may actually help push the banks towards lending to riskier clients because it is supposed to lower longer-term yields. If banks get less income from lending to the government, they may be more inclined to lend to consumers who pay more interest.

Even if this works, it is not at all clear that the cure isn’t worse than the disease. I, for one, am not really interested in another credit.

Posted by Martin Gremm (Pivot Point Advisors)

About the author

Marc Schindler, CFP®

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