Why the US Federal Reserve has become the most important bank of all time: Kohler

The most remarkable thing in the US Federal Reserve’s statement this morning was not the cut in the cash rate target to near zero, although it was certainly a bit more than the market was expecting.

The most remarkable thing in the US Federal Reserve’s statement this morning was not the cut in the cash rate target to near zero, although it was certainly a bit more than the market was expecting.

It’s the fact that the Fed is now one of the largest and most important commercial banks of all time – by necessity and virtually by default, it is nationalising the US banking system. In a sense, the Fed is eating the banks.

That meal in front of Ben Bernanke is only likely to get bigger with the incredible Bernard Madoff fraud, as one by one banks and other institutions shamefacedly own up to massive losses in a Ponzi scheme. Confidence in the private financial system has suffered yet another huge blow.

The Fed is simultaneously fighting deflation and a failure of confidence in banking. The first of those tasks will mean a Fed funds rate at or close to zero for a long time.

The second means that the Fed has to step into the breach. This morning’s Federal Open Market Committee statement said that early next year the Fed will begin extending “credit to households and small businesses”. It is also “evaluating the benefits” of buying long term Treasury securities”.

Including its loans to Bears Stearns and American International Group, the Fed’s balance sheet now stands at $US2.2 trillion and is certain to expand further.

This morning the Fed confirmed that over the next few quarters it will buy “large quantities” of agency debt and mortgage-backed securities to support the mortgage and housing markets, and that it “stands ready” to do much more if necessary.

In fact it seems the Federal Reserve is about the only fully operational bank in America, and Ben Bernanke is Atlas with the world upon his shoulders.

The cut in the Fed funds rate to a target range of between 0% and 0.25% merely confirms what is already happening in the short term money markets: US Treasury bills are being issued at yields of 0.00%.

That is, the market is not demanding any return at all on government paper; funds are, in effect, paying the US Government to guard their money.

But the other important development is that once again the Fed and the European Central Bank are out of step.

On Monday night the ECB president, Jean-Claude Trichet, told journalists that he was wary of taking rates too low and signalled that the ECB was now pausing its rate cuts.

The European official cash rate is now 2.5%, the highest in the industrialised world. Trichet said on Monday: “Do we have a feeling there is a limit to the decrease in rates? At this stage, certainly yes.”

The Fed started cutting rates in September last year and by July had cut by 2.75% to 2%. In July the ECB actually increased rates by 0.25%.

For a few weeks, though, they got together. Three days after the collapse of Lehman Brothers on 15 September the Fed and the ECB led co-ordinated action by several central banks to reduce rates and provide extra liquidity the system. That led to several weeks of alignment between the US and European central banks.

That now appears to have broken down again. Woe is Europe.

This article first appeared on Business Spectator