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The Great Interest Rate Illusion

The Great Interest Rate Illusion
March 31
10:35 2017

(DR) – Now that the Fed went ahead and done what all the Fedheads had said that they would do on March 15, the question is, what did the Fed actuallydo?

Did they tighten credit? No.

Did they reduce the size of the Fed’s balance sheet? No.

Did they decrease the growth rate of the money supply? No.

Did they raise interest rates?


That last one may surprise you. I just said the Fed didn’t raise interest rates.

What do I mean?

Raising interest rates means raising banks’ costs of funds so that the banks will charge their customers higher rates.

Banks make money when the amount of interest they can charge on the loans they make exceeds the amount of interest they have to pay depositors (savings, checking, etc.) — the cost of funds.

The key takeaway is that, the lower the cost of funds, the more money banks make on the loans they make. And vice versa.

But the Fed hasn’t raised banks’ cost of funds at all. In fact, it’s lowered them.

The Fed has merely increased the Interest on Excess Reserves (IOER) that it pays the banks for their $2.7 trillion in reserve deposits at the Fed.

IOER is a de facto subsidy the Fed pays to the banks for the couple trillion in reserve deposits they hold at the Fed. Increasing it increases the cash subsidy to the banks.

Increasing the amount of interest the Fed pays on those reserves isn’t a tightening. That’s because raising IOER doesn’t raise the banks’ cost of funds. It lowers it.

Raising IOER does not make it more difficult for the banks to make loans. It makes it easier. It increases their profits. By lowering their costs and increasing their profits, increasing IOER makes it easier for banks to make loans, not harder.

In other words, the Fed hasn’t been raising bank costs at all since it began this rate cycle. Au contraire. The Fed has been increasing the interest it pays on excess reserves.

Essentially, the Fed isn’t tightening. It’s easing. But the market doesn’t see it.

It’s as if the Fed is the hypnotist and money market traders are the subjects of a great experiment in mass hypnosis.

The Fed had essentially told the market, “Keep your eyes on the spiral. You are getting sleepy, very sleepy. Now you believe that interest rates are rising.” This was a done deal for the March FOMC meeting, with more to follow.

Traders believe that the Fed has tightened, so they act as if the market is in fact tighter.

But money is really much looser than the Fed would have us believe.

There has been no tightening because the Fed has not removed one dime of the massive excess cash it pumped into the banks over the course of QE. That pile of excess cash means that there are no restraints on loan growth other than borrowers desire to borrow.

So, while the Fed did not tighten money one iota, rates moved up because of the power of suggestion.

With trillions in excess cash lying around the Fed can only suggest.

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