Treasury Arbitraging Fed’s Low Rates
It should be evident to anyone with any financial markets/economics experience that the Federal Reserve needs to raise rates. They won’t, however, as 0% rates create an excellent opportunity for banks to arbitrage the difference in Fed rates and Treasuries.
How it Works
The banks with access to the Federal Reserve windows can borrow overnight at 0-.25%, the rate that the Federal Reserve has set. Then, utilizing their new capital, they can buy treasuries which yield roughly 1.5% per year on the 1 year bond. As you can see, the system is incredibly profitable for the banking industry, with virtually no risk of loss.
Why the Fed Does It
Investors need to realize that before the American populace, the Federal Reserve works for the banking system and the government. By keeping rates low, banks are able to milk the treasury markets, increasing their reserves (which was the goal of TARP as well), and the government is able to borrow at extremely cheap rates. Though the Federal Government cannot print money to directly pay off its debt, the Federal Reserve can issue credit which is then borrowed by banks to buy the Federal Government’s debt. Same thing, easy excuse.
Inflation is Coming
When the Federal Reserve closes up its window and allows rates to rise, inflation is a certainty. The Fed, through its FOMC actions, raises and lowers interest rates by altering the money supply available to banks. When rates are tightened, the Fed is unlikely to actually lower the money supply but instead shut down its lending facilities to banks, releasing the stranglehold it currently has on rates. When that happens, the arbitrage advantage will slowly fade and banks will have to make loans to businesses and consumers at higher margins. Banks can currently lend up to 10 times the amount they have in reserve, making it entirely possible for the M2 money supply to expand from $8 trillion to $14-15 trillion, a vast increase. At that point it will be too late. The Federal Reserve cannot take money out of the monetary base, it can only reduce the amount of money in circulation.
