Gettin' swindled by the Fed
The Washington Post today has an interesting story on the Fed's "exit strategy." The crux of the article is that, for an exit strategy to work, Fed officials will have to dutifully watch the impact that the Fed's short-term interest rates have on long-term rates. If Fed officials keep short-term rates too low for too long, they could spur fears of inflation that would manifest themselves through a rise in long-term rates. However, if short-term rates rise too quickly then they could stifle any economic recovery.
The Post casts this scenario as a fine line that must be walked by studious Fed officials to achieve recovery without spurring runaway inflation. Essentially, the Fed is trying to sell confidence in itself. As Karen Dynan of the Brookings Institution puts it, "You're trying to inspire confidence that you know what you're doing, which can help put the brakes on any incipient inflation without damaging the recovery." In other words, after more than doubling the monetary base in the last year and a half, the Fed recognizes that inflation is upon us but will now try to bluff the market.
However, as the article points out, the Fed has a new policy tool to use as a result of the TARP bailout legislation. In addition to targeting the daily Federal Funds Rate - its traditional policy tool - the Fed is now able to pay interest on deposits made by member banks. Because the Fed is able to print new money at will, it can now pay member banks not to make loans by printing new Federal Reserve notes and using them to pay interest on holdings. The policy goal of doing this is to take money out of circulation by encouraging banks to hold their assets at the Fed instead of using them to make loans. As the Fed offers higher interest rates, banks will take more money out of circulation and deposit it with the Fed where they bear zero risk and still turn a profit.
The outcome of this policy is a windfall for Wall Street. Whenever the Fed creates new money, it has effectively taxed the wealth of all dollar-holders by making each dollar less valuable. Traditionally, this backdoor tax has been used to profit the federal government with Wall Street serving as a middleman. The Treasury issues government bonds to be sold on Wall Street and Wall Street inevitably buys them knowing that they can later flip them to the Fed, which will print new money to purchase government debt. When the bonds come due, the Fed typically rolls over government debt, meaning that the Federal Reserve system serves as little more than a hidden taxation scheme that allows the federal government to monetize its debt with the assistance of Wall Street.
However, now the Fed can use its inflationary tax to reward Wall Street directly by paying interest on deposits. The result of this policy will be a massive wealth transfer from the bulk of Americans (and other holders of U.S. dollars) to Fed member banks.
It's the bailout that keeps on bailin' out!
