One of the stranger policies to come out of the financial crisis is all about the Federal Reserve’s interest on excess reserves. In short, the Fed is currently paying banks to park their reserves at the Fed. All US$2.4 trillion of them. That may or may not be holding back bank lending into the real economy – if you’re earning interest at the Fed, why lend out the money? Especially when interest rates are historically low too.
So, according to the latest minutes, the Fed is now considering lowering that interest rate. If banks can’t earn as much interest leaving their cash at the Fed, perhaps they will lend out some of those reserves? And that will get the economy going (because debt is synonymous with growth in the wonderful world of central banking).
Well the banks read the Federal Reserve meeting minutes and promptly threw a wrench into the plan. If interest on reserves were to fall, executives at two banks announced they would have to charge depositors for keeping their funds at the bank.
Before you go blaming bankers’ greed, you should know that this sort of thing is always the government’s fault somehow. It’s just a question of finding out how. In this case, the government charges the banks for their deposit insurance program, so taking deposits costs money. Right now, they can regain that money by parking deposits at the Federal Reserve. But without interest on their reserves, taking deposits is a losing business. And losing businesses have to raise prices, or in this case lower interest paid on deposits.
If only the banks would get greedy and start lending again. The economy might actually grow. It turns out that’s not on the cards. The Financial Times quotes one of the two executives just mentioned:
‘"It’s not as if we are suddenly going to start lending to [small and medium-sized enterprises]," said one. "There really isn’t the level of demand, so the danger is that banks are pushed into riskier assets to find yield."‘
So what would the banks do with all those excess reserves if they stop earning interest? The same thing American and European savers have been doing:
‘Other bankers said that a move to negative rates would not only trim margins but could backfire for banks and the system as a whole, as it would incentivise treasury managers to find higher-yielding, riskier assets.‘
Yes, the banks might be forced to go and invest in the countless bubbles forming in the economy thanks to the loose monetary policy that is trying to save them. How ironic.
Fund manager John Hussman explained where this monetary policy is leaving investors:
‘The problem with bubbles is that they force one to decide whether to look like an idiot before the peak, or an idiot after the peak. There’s no calling the top, and most of the signals that have been most historically useful for that purpose have been blaring red since late-2011.’
It’s a tough dilemma. An idiot now or an idiot later? Well, we’ve got five ideas on how you can opt out of the idiocy here. But even those ideas are at least indirectly affected by monetary policy.
The real question is the timing of the bubble bursting. And can a bubble burst if central banks are at the ready to do ‘whatever it takes’ to prevent it, as European Central Bank president Draghi put it?
A good rule of thumb in this environment is to invest early, trade late. In other words, make long term buy and hold decisions before any bubble. And once you do suspect there is a bubble in an asset class, trade it with strict buy and sell prices in mind, including stop losses.
That advice is a little late for the long term investors, we know. But why not give trading a try with the brand new unique trading system our friend Brian Jagger developed? It’s bubble independent. You won’t even need to read The Daily Reckoning to know what’s going on for the trades to work.
for The Daily Reckoning Australia