The FED's new tactic

My first inclination is always to believe that the FED (and all of government for that matter) is incompetent, not that they can't do anything, but that everything they do eventually turns out to be more trouble than it's worth. But what could go wrong with the latest tactic by the FED of paying interest on the excess reserves of member banks held at the FED? It's not hard to figure out what this policy accomplishes in the present situation, banks will leave excess reserves deposited at the FED rather than lend. This nullifies the fractional reserve multiplier by preventing the banks from lending to the extent that they normally would. It might surprise you, but the FED is pursuing policies that inhibit banks' desires to lend. At the moment, lending is not very safe or profitable, but to the extent that banks might consider lending, the FED will pay them not to do so.

So what will be the longer term effects of the FED's newfound magic policy that allows them to flood the banks with fiat money while avoiding the usual effects of the fractional reserve banking money multiplier? At the moment, this policy is working to calm the stock market and has not caused an equivalent level of price inflation. However, a plausible scenario for the future is as follows:

1. The FED creates an expectation of inflation by creating massive amounts of new money as they purchase RMBS and CMBS securities to prevent the failure of large banks.

2. Pressure to increase the interest on long term treasury securities mounts as the FED continues its buying program to keep their interest rates low.

(This is where we are now.)

3. The FED intervention (by money creation) needed to keep interest rates at very low rates mounts. Eventually, the FED must abandon this policy or risk triple digit price inflation.

4. As interest rates begin to rise, banks begin to lend since rates look more profitable, and they reduce their excess reserves. As they do so the money supply increases dramatically due to the fractional reserve lending money multilier.

5. The FED increases the interest on excess reserves in an effort to reduce their loss.

6. The FED increases the discount rate in an effort stem the fractional reserve lending.

7. The FED increases the reserve ratio in an effort stem the fractional reserve lending.

8. The FED ends the TALF and TARP programs repatriating the devalued securities to their original owners. However, this can only be done to the extent that it does not threaten the survival of the big banks and the FED will be left with the worst of the lot.

8. As price inflation expectations increase, the FED begins to sell assets into the market to reduce the money supply, but finds that the assets they own (even treasury securities) have lost value and are not worth what they paid for them. Consequently not all of the excess money can be removed.

Beyond that point, the future is even less certain. The FED, the Treasury, the Congress and the President will certainly intervene to save the economy and as usual will make the future from that point even worse than it would have been otherwise. Avoiding the crack-up boom does not seem possible at the moment, but we can always hope that at some point government will realize that further interventions only take us closer to the day of reckoning, and abandon those policies.