Time to close the Fed window a little?
January 24, 2011
In response to the financial crisis, the Federal Reserve flung its lending window to banks open wide by making funds available to them at near-zero interest rates. With improvement in the financial condition of the banking sector, it may be time to start closing that window.
The sweetheart deal for banks
When money is available to banks at low interest rates, it makes it easier for them to profit by investing or lending that money out at higher rates.
To help stabilize the banking system, the Federal Reserve has been giving banks a sweetheart deal by making funds available to them at less than 0.20 percent. Even with low mortgage rates, this has given banks a very healthy spread between the rates at which they lend and the rates at which they borrow. Historically, this spread has averaged 2.77 percent; in 2009 and 2010, it averaged 4.70 percent.
This has helped get banks back on their feet. By and large, 2010 bank earnings have been a substantial improvement over 2009. To some extent, bank earnings have enjoyed a one-time bump because loss reserves have been reduced, but that's part of the point. With banks no longer teetering on the brink of insolvency, they can be expected to get back to constructive business strategies rather than just leaning on the Fed for support.
The price of low interest rates
The Fed funds rates influence other short term rates, including rates on savings accounts, money market accounts, and CDs. This effectively takes money out of the pockets of bank depositors--and by extension, it takes money out of the economy.
Now that banks are back on their feet, it may be time to challenge them to get back to actively pursuing profitable lines of business, rather than depending so much on the spread in interest rates. In other words, this could be a good time to shut the Fed window a little. If CD, savings, and money market rates follow Fed fund rates higher, it would start to give something back to depositors--and perhaps to the economy at large.