The Fed Needs to Raise Short Term Rates

The Federal Reserve finds itself in a very sticky situation. The macroeconomic situation is lukewarm. They do not want to repeat the mistakes of the Japanese Federal Reserve by being too aggressive in tightening, choking off any economic gains.

There are still “green shoots” (remember those?) around. However, they take a while to grow. Expectaions and confidence are so low-it really is hard to see them.

However, the current policy the Fed is pursuing allows banks to take virtually no risk in their operations. They simply borrow from the Fed at 0%, and reinvest in government securities at various points on the yield curve-locking in a guaranteed rate of return. When you hear “surfing the curve” used, that is what they mean. Banks buy some 2 yr, 5 yr, 7yr, 10 yr, and 30 yr dated securities and lock in a sum rate of return-hedge it in the futures market and then go play golf.

It is time for banks to start acting like banks again.

The only way to get banks off the fix of government debt is to make that debt riskier. The only way to do that is squeeze them. Increase short term rates by 1%.  This line of thinking goes against the grain of probably 100% of economists out there. Except for one. Thomas Hoenig has been a dissenting vote on Fed policy.

There are a couple of reasons why this tactic might be good.  Savers would be rewarded with higher rates of interest on their bank accounts.  This will  also help retirees who have been badly beaten up by this recession. Banks would have to go out and find business to lend to.  Bankers would be on the look out to extend lines of credit, fund small business expansion via loans that should yield higher rates of return than a risk free government instrument. That action creates economic expansion.

At the same time, the Fed needs to keep it’s balance sheet big.  It needs to be flexible with collateral.  It should pursue the principles of “easy money”, but just raise the interest rate to increase the amount of risk there is in holding government securities.

Like I said, “it’s a sticky situation”.