Since 2008, the Federal Reserve has been paying banks interest on their reserves. This sets a floor on the overnight lending rate for banks.

In other words, the Fed pays banks interest on their reserves in order to control the federal funds rate. When you hear about the Fed raising rates or lowering rates or not changing rates, it is in reference to the federal funds rate.

Before 2008, the Fed controlled the federal funds rate essentially by increasing or decreasing its balance sheet. There was a direct correlation with the money supply.

While there is still a correlation between the two, the Fed is less dependent on the balance sheet for controlling interest rates. You can technically have a balance sheet that is increasing while the Fed is hiking rates. This might be difficult to sustain, but you can see how the Fed has more flexibility with its balance sheet now.

Bank Bailouts

The banking system of today in the United States does not resemble anything close to a free market system. Just the existence of the Fed and the FDIC make it so, but it goes far beyond that as well.

The Fed is still paying banks not to lend money. So anything a bank lends would logically be at a higher rate than what they can get for free from the Fed.

If there is any significant risk to a loan, a bank would have to demand a much higher interest rate. If you can automatically get 5% from the Fed, why would you lend to a risky borrower for only, say, 6%?

The interest paid by the Fed is a subsidy. You could say it is a bank bailout. The bailouts from 2008 never ended.

You can read the FOMC monetary policy statements. In the Implementation Note, it directs the Fed to pay a certain amount in interest to the banks. Whenever the Fed “raises rates”, it is really this rate that it is hiking.

Deficits Matter

With rates having gone up from near zero, it means the Fed is paying out a much greater amount these days to the banks as compared to a few years ago.

At the end of each fiscal year, the Fed remits money back to the Treasury if it made a “profit”.

I know, the Fed doesn’t actually produce any useful goods or services that it sells. It is only profitable in the sense that it has the power to create money out of thin air. When it creates money to buy up U.S. government bonds and mortgage-backed securities, it gets paid the interest on those securities.

After the Fed pays for its buildings and computers and workforce, along with any other expenses, it doesn’t get to keep the difference. It is sent back to the Treasury.

With the Fed currently paying higher interest rates to banks, it means less money is left over, or perhaps no money at all. This means that with the Fed paying banks more, it is indirectly causing the deficit to rise even faster than it otherwise would have.

It means that the national debt will just keep going up. And if the Fed is essentially forced to keep rates at a higher level compared to before, this will just help explode the national debt even more, as if a profligate Congress and president weren’t enough.

Why Would the Fed Policy Change?

I see no reason that the Fed would change its policy at this point. It is what they call a “monetary tool” they use to control the economy. They can more easily manipulate interest rates.

Congress doesn’t seem too concerned about spending trillions of dollars that it doesn’t have. So why should the Fed worry about tens of billions of dollars?

The Fed’s main reasons for existence are to support the major banks and to control the economy. Paying interest on bank reserves help both of those goals.

So the only way the Fed would change this policy is if the debt became so terrible that Congress were forced to tighten its belt and wanted the Fed to do the same.

We have found out the last couple of years that there are limits to the insanity. It has shown up as higher consumer price inflation, and it did force the Fed to increase interest rates and to stop expanding its balance sheet, at least for now.

Even though the Fed probably feels like it has more “monetary tools” to fight the next financial crisis, it doesn’t mean that there won’t be another financial crisis.