Authored by Chris Hamilton via Econimica blog,
As the Fed is in the midst of a rate hike cycle, it seems important to remember why this cycle is like no previous rate hike cycle. The mechanics of this hiking cycle are completely unique and experimental…thus the outcome is far more of an unknown than “normal”.
Why? In a typical cycle, the Fed would sell a relatively small portion of its assets…er, balance sheet (typically short duration bills and notes) to banks. This would withdraw some of banks liquid funds (replacing them with less liquid assets) and create “tightness”. This tightness would push overnight lending rates higher and the daisy chain of rising rates would work its way through from the shortest eventually all the way to the 30yr Treasury bonds.
However, this time, nothing like that is happening. This is because the Fed sold all its short term notes/bills (in Operation Twist) and bought longer duration MBS (mortgage backed securities) and longer duration Treasuries in Quantitative Easing to the tune of $4.5 trillion. Further, since the Fed bought most of these assets from large banks, these banks held much of the proceeds from these sales at the FRB (Federal Reserve Bank). For the Fed to perform typical rate hikes, it would need to remove most of the $2.1 trillion banks are now sitting on in excess reserves @ the FRB…likely creating a crisis in the process. Conversely, if the Fed can’t contain the $2.1 trillion at the FRB, and the reserves are leveraged into the market…stand back in awe of the mother of all bubbles.
Thus, the Fed has instead determined to raise rates via paying banks interest on these excess reserves to maintain the reserves at the Federal Reserve. In short, pay banks not to lend money, not to invest the reserves. This is just like Federal programs that paid farmers not to farm…IOER (interest on excess reserves) pays big bankers not to bank.
This post was published at Zero Hedge on Jun 30, 2017.