Responding to earlier presidential pressure, the Federal Reserve is expected to raise interest rates this week for the third time since November, from a fed funds target of 1% to 1.25%. But as noted in The Guardian in a March 2017 article titled “Trump Is Set to Win the Battle on Interest Rates, but US Economy Will Pay the Price”: An increase in the base rate, however small, will tighten the screw on younger voters and some of the poorest communities who voted for him and rely on credit to get by. More importantly for his economic programme, higher interest rates in the US will act like a honeypot for foreign investors . . . . [S]ucking in foreign cash has a price and that is an expensive dollar and worsening trade balance. . . . It might undermine his call for the repatriation of factories to the rust-belt states if goods cost 10% or 20% more to export. In its Global Financial Stability report in April, the International Monetary Fund issued another dire warning: projected interest rises could throw 22% of US corporations into default. As noted on Zero Hedge the same month, “perhaps it was this that Gary Cohn explained to Donald Trump ahead of the president’s recent interview with the WSJ in which he admitted that he suddenly prefers lower interest costs.” But the Fed was undeterred and is going full steam ahead. Besides raising the fed funds rate to a target of 3.5% by 2020, it is planning to unwind its massive federal securities holdings beginning as early as September. Raising interest rates benefits financial institutions, due to a rise in interest on their excess reserves and net interest margins (the difference between what they charge and what they pay to depositors). But borrowing costs for everyone else will go up (rates on student loans are being raised in July), and the hardest hit will be the federal government itself. According to a report by Deloitte University Press republished in the Wall Street Journal in September 2016, the government’s interest bill is expected to triple, from $255 billion in 2016 to $830 billion in 2026. The Fed returns the interest it receives to the Treasury after deducting its costs. That means that if, rather than dumping its federal securities onto the market, it were to use its quantitative easing tool to move the whole federal debt onto its own balance sheet, the government could save $830 billion in interest annually – nearly enough to fund the president’s trillion dollar infrastructure plan every year, without raising taxes or privatizing public assets. That is not a pie-in-the-sky idea. Japan is actually doing it, without triggering inflation. As noted by fund manager Eric Lonergan in a February 2017 article, “The Bank of Japan is in the process of owning most of the outstanding government debt of Japan (it currently owns around 40%).” Forty percent of the US national debt would be $8 trillion, three times the amount of federal securities the Fed holds now as a result of quantitative easing. Yet the Bank of Japan, which is actually trying to generate some inflation, cannot get the CPI above 0.2 percent. The Hazards of Operating on the Wrong Model The Deloitte report asks: Since the anticipated impact of higher interest rates is slower growth, the question becomes: why would the Fed purposely act to slow the economy? We see at least two reasons. First, the Fed needs to raise rates so that it has room to lower them when the next recession occurs. And second, by acting early, the Fed likely hopes to choke off inflationary pressure before it starts to build. Rates need to be raised so that the recession this policy will trigger can be corrected by lowering them again – really? And what inflation? The Consumer Price Index has not even hit the Fed’s 2% target rate. Historically, when interest rates have been raised in periods of tepid growth, the result has been to trigger a recession. So why raise them? As observed in a June 2 editorial in The Financial Times titled “The Needless Urge for Higher Borrowing Costs”: In this context, the apparent determination of the Fed in particular to press on with interest rate rises looks a little peculiar. Having created expectations that it was likely to tighten policy with three quarter-point increases over the course of 2017, the Fed is acting more like a party to a contract that feels the need to honour its terms, than a central bank that takes the data as it finds them. [Emphasis added.] In the six months since President Trump was elected, the Fed has pressed on with two rate hikes and is proceeding with a third, evidently just because it said it would. Impatient bond investors are complaining that it has found one excuse after another to postpone the “normalization” it promised when market conditions “stabilized;” and in his presidential campaign, Donald Trump attacked Janet Yellen personally for keeping rates low, putting her career in jeopardy. She has now gotten with the program, evidently to restore the Fed’s waning credibility and save her job. But the question is, why did the Fed promise these normalization measures in the first place? As then-Chairman Ben Bernanke explained its “exit strategy” in 2009: At some point, . . . as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road. . . . [B]anks currently hold large amounts of excess reserves at the Federal Reserve. As the economy recovers, banks could find it profitable to be more aggressive in lending out their reserves, which in turn would produce faster growth in broader money and credit measures and, ultimately, lead to inflation pressures. The Fed evidently believes that the central bank needs to tighten monetary policy (raise interest rates and sell its bond holdings back into the market) because the massive “excess reserves” held by the banks (currently ringing in at $2.2 trillion) will otherwise be lent into the economy, expanding the money supply and triggering hyperinflation. Which, as David Stockman puts it, shows just how clueless even the world’s most powerful central bankers can be in matters of banking and finance . . . . Banks Don’t Lend Their Reserves There need be no fear that banks will dump their excess reserves into the market and create “inflation pressures,” because banks don’t lend their reserves to their commercial borrowers. They don’t because they can’t. The only thing that can be done with money in a bank’s reserve account is to clear checks or lend reserves to another bank. Reserves never leave the reserve system, which is simply a clearing mechanism set up by the central bank to facilitate trade among banks. Technically, dollars leave the system when a depositor pulls money out of the bank in cash; but as soon the money is spent and redeposited, these Federal Reserve Notes go back into the banking system and again become reserves. Not only do banks not lend their reserves commercially, but they do not lend their deposits. Banks create deposits when they make loans. As researchers at the Bank of England have acknowledged, 97 percent of the UK money supply is created in this way; and US figures are similar. Banks do not need reserves or deposits to make loans; and since they are now flooded with reserves, they have little incentive to pay interest on the deposits of “savers.” If they do not have sufficient incoming deposits at the end of the business day to balance their outgoing checks, they can borrow overnight in the fed funds market, where banks lend reserves to each other. At least they used to do this. But since the Fed began paying Interest on Excess Reserves (IOER) in 2008, they have largely quit lending their reserves to each other. They are just pocketing the IOER. If they need funds, they can borrow more cheaply from the shadow banking system – the Federal Home Loan Banks (which are not eligible for IOER) or the repo market. So why is the Fed paying interest on excess reserves? Because with the system awash in $2.2 trillion in reserves, it can no longer manipulate its target fed funds rate by making reserves more scarce, pushing up their price. So now the Fed raises the fed funds rate by raising the interest it pays on reserves, setting a floor on the rate at which banks are willing to lend to each other – since why lend for less when you can get 1.25% from the Fed? That is the theory, but the practical effect has been to kill the fed funds market. The Fed has therefore implemented a new policy tool: it is “selling” (actually lending) its securities short-term in the “reverse repo” market. The effect is to drive up the banks’ cost of borrowing in that market; and when this cost is passed on to commercial borrowers, market rates are driven up. Meanwhile, the Fed is paying 1% (soon to be 1.25%) on $2.2 trillion in excess reserves. At 1%, that works out to $22 billion annually. At 1.25%, it’s $27.5 billion; and at 3.5% by 2020, it will be $77 billion, most of it going to Wall Street megabanks. This tab is ultimately picked up by the taxpayers, since the Fed returns its profits to the government after deducting its costs, and IOER is included in its costs. Among other possibilities, an extra $22 billion annually accruing to the federal government would be enough to end homelessness in the United States. Instead, it has become welfare for those Wall Street banks that largely own the New York Fed, the largest and most powerful of the twelve branches of the Federal Reserve. Paying IOER is totally unnecessary to prevent inflation, as evidenced again by the case of Japan, where the Bank of Japan is actually trying to fan inflation and is now charging banks 0.1% rather than paying them on their excess reserves. Yet the inflation rate refuses to rise above 0.2%. Banks cannot lend their reserves commercially and do not need to be induced not to lend them. The Fed’s decision to raise rates by increasing IOER just increases public and private sector borrowing costs, slows the economy, threatens to bankrupt businesses and consumers, and gives another massive subsidy to Wall Street.