The Fed's "Exit Plan" Is Just Another Secret Gift To Wall Street

[MikeWB]

The Fed's "Exit Plan" Is Just Another Secret Gift To Wall Street

Posted Feb 08, 2010 09:50am EST by Henry Blodget in   Investing, Recession, Banking
Related: SPY, DIA, XLF, QQQQ, TLT, UUP, ^GSPC
The Fed is planning to detail its "exit plan" this week, the WSJ says.  This exit plan is the means by which the Fed will gradually reverse the tremendous stimulus it is still pumping into the economy and financial system.

As we've noted often over the past year, the Fed is in a bind.  During the financial crisis, it bought hundreds of billions of dollars of real-estate and other assets from banks to reduce mortgage rates and ease the pressure on bank balance sheets.  This, in turn, pumped hundreds of billions of new dollars into the economy, which has enabled the banks--and bankers--to make a killing over the past year.  The question is how the Fed can reverse this stimulus without killing the economy.

The idea behind giving the banks cheap money was that the banks would lend it to consumers and businesses.  Unfortunately, that hasn't happened: Since the start of the crisis, bank lending has fallen off a cliff.  The banks are, however, lending to the Federal government, which needs to fund record deficits by borrowing more than $1 trillion a year.  The combination of the Fed's desire to stimulate lending via cheap money and the government's desire to stimulate the economy by running a huge deficit has made it a great time to be a bank: Banks can borrow from the government at artificially cheap rates and then lend the money back to the Federal government at higher rates, pocketing the difference.

And now it's going to get even better to be a bank.

Why?

Because the first part of the Fed's exit plan will reportedly be to increase the amount of interest the Fed pays on "excess reserves."

Banks are required to keep a certain percentage of their assets in cash at the Federal Reserve.  Any cash above this required amount is "excess reserves," and the Fed is currently paying 0.25% interest on these reserves.  The Fed's exit plan will call for increasing this interest rate, to encourage the banks to keep more money in excess reserves instead of lending it into to the economy and thus expanding the money supply.

The idea here is that, by increasing the amount of money on account at the Fed, the Fed will reduce the amount of money that gets loaned out to businesses and consumers, thus forestalling inflation.  Increasing interest paid on excess reserves will also put off the day that the Fed has to start selling its real-estate assets back to banks, a process that might create taxpayer losses and raise mortgage rates, which the Fed is loathe to do.

Of course, in the process of increasing interest paid on reserves, the Fed will be paying banks even more not to lend.  In the process, it will be giving banks yet another way to take nearly free money from the taxpayer and give it back to the government at a higher rate--and then pocket the difference.

It's a great time to be a banker.