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More Secret Bank Bailouts Coming

Written by Geoffrey Pike
Posted July 31, 2015

The Federal Open Market Committee (FOMC) wrapped up another meeting this past week. Its latest statement on monetary policy did not offer much guidance to investors on when to expect the much anticipated “rate hike.”

Some analysts expect the Fed to raise rates in September, while others are anticipating the announcement in December. It may just depend on if there are any surprises to come in the economy.

We have to be clear on what it means for the Fed to hike interest rates. This refers to the federal funds rate, which is the overnight borrowing rate for banks.

While the Fed’s hiking of the federal funds rate could impact market interest rates, the anticipation of the Fed raising rates has not seemed to have too much of an effect on Treasury yields. In fact, rates were actually going down for a period earlier this year, even when the market was expecting a higher federal funds rate.

In the past, the federal funds rate was important because it dictated monetary policy. It is actually a target rate. If the Fed wanted to raise the rate, it would tighten its money supply. If it wanted to lower the rate, then it would create new money by buying more government debt.

The federal funds rate target would essentially dictate whether we had monetary inflation, monetary deflation, or stable money.

The monetary policy going forward is no longer a surprise to us. The FOMC tells us exactly what it is doing and what it plans to do with the monetary base, the money supply directly controlled by the Fed, in the near future.

The Fed ended QE3 — its third round of so-called quantitative easing — near the end of 2014. Since that time, the Fed has basically kept a stable money supply, just rolling over maturing debt.

It makes the federal funds rate less relevant today than it was in the past. The Fed can currently increase or decrease the money supply, and it will have virtually no impact on the federal funds rate.

How to Raise the Federal Funds Rate

Since late 2008, the Fed has expanded the monetary base approximately five-fold. It has gone from just over $800 billion to $4 trillion. This is unprecedented in the Fed’s 100-year history.

Most of this new money went into bank reserves. This was also a change from the past. Before 2008, most banks would typically loan out about 90% of the new deposits that came in. They have a reserve requirement of just 10% (approximately).

With QE1, QE2, and QE3, most of the new money went into excess reserves. In other words, the banks did not loan out most of the new money.

Another change that happened in 2008 was that the Fed started paying interest on bank reserves, including their excess reserves. This was originally planned before the downturn of 2008 and was supposed to be implemented in 2011. When the crash happened, Congress permitted the Fed to implement this right away. Since that time, the Fed has been paying banks 0.25% for their reserves.

Since most of the banks have excess reserves far larger than the requirements, they don’t need to borrow money overnight to meet requirements. This is why the federal funds rate has been below 0.25%: the demand for overnight borrowing is so low.

The main reason stated for the Fed to pay interest on bank reserves is because it gives it more control over monetary policy. This is true. It basically sets a floor on the federal funds rate.

Some institutions, such as the government-sponsored enterprises (GSEs) — which include Fannie Mae and Freddie Mac — do not get paid for excess reserves. Therefore, there is an arbitrage opportunity for banks in borrowing overnight money from the GSEs and earning 0.25%, while paying a rate somewhere just below that (the federal funds rate).

It gets a little complicated, but essentially the federal funds rate will stay just below the interest rate being paid to banks for their reserves, at least in our current environment.

There are few ways that the Fed will be able to raise the federal funds rate. It could increase reserve requirements dramatically to necessitate more borrowing by the banks, but this is highly unlikely.

The Fed could also sell off the majority of its assets and severely deflate the money supply. This will almost definitely not happen.

The last option, and really the only viable one, is for the Fed to increase the rate it pays to banks for their reserves. It could raise it from 0.25% to whatever amount it wants. The higher the rate paid on reserves, the higher the federal funds rate will go.

If the Fed goes through with a rate hike in September or December, this is what it is going to do. The banks will get paid more to sit on their deposits and not loan them out.

Bank Bailouts

Almost everyone paying attention knows about the massive bank bailouts that happened in late 2008 and 2009. This was basically a direct bailout by the Fed, and it was widely known.

Since that time, the Fed has wised up. As part of its quantitative easing, it started purchasing mortgage-backed securities. Its stated purpose was to lower mortgage rates. And to some degree, this was correct.

But we can be reasonably sure that the Fed was buying these mortgage-backed securities for what they were originally worth — before a large number of people started defaulting on their home loans.

In other words, the Fed was buying this mortgage debt and paying far more than what it was actually worth. It was taking the bad debt off of the hands of the banks and big financial institutions. It was a bailout, but it was never called that by anyone at the Fed, or really anyone in the mainstream media. And for the most part, they got away with it. It was a bank bailout without most people ever realizing it.

The Fed has also been paying 0.25% interest on bank reserves since late 2008. This has been essentially free money to the banks, because they weren’t anxious to make risky loans with this money anyway. Again, this has been another form of a bank bailout, with barely anyone noticing it.

Now the Fed is likely to raise the federal funds rate, which it can only feasibly do by paying higher rates on bank reserves. In other words, the bank bailouts are about to increase. Instead of banks “earning” 0.25% interest, they will get even more just for parking their deposits with the Fed.

Bank Bail-Ins

Ever since bank deposits were seized (called bank bail-ins) in Cyprus in 2013, there have been some worries that this would happen elsewhere. If you are in Greece, you should worry. But what about in the United States?

When the original and well-known bank bailout was happening in late 2008, one congressman said he was getting calls from constituents running about 50/50. He said the calls were either “no” or “hell no.” The American people were quite angry about the bailouts — although not quite enough to oust the majority of incumbents at the next election.

Since that time, the Fed has continued to hand over free money to the banks in the form of interest on reserves and buying up the bad mortgage-backed securities.

There has been no backlash from this. Since that is the case, why would the Fed ever do a direct bailout of the banking system ever again? Why would it risk some kind of a revolution when the Fed can just quietly bail out the banks with barely anyone noticing?

And we most certainly are not going to see bank bail-ins. Why would the Fed seize money from bank accounts when it can accomplish essentially the same thing by creating new digital money?

If you live in the United States and you have your money in a U.S. bank, your money is almost certainly safe from direct confiscation, assuming you stay within the FDIC limit.

Despite this, your money isn’t safe from losing its value over time because of the Fed’s monetary inflation. For this reason, you should own some gold for the long term.

But if you need to have liquid money in a bank, it will be safe. You just aren’t going to earn anything significant in interest, and it will likely lose value over time.

Until next time,

Geoffrey Pike for Wealth Daily

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