Right now, it’s basically a case of the Fed versus the economy. You might say, “Wait a second. Isn’t the Fed supposed to help the economy?”
Well, not exactly. They may want to help the economy, but helping the economy actually isn’t job one. Job one is helping the banks. The Fed was essentially created to prop up the banking system and prevent bank runs.
Everything else it tries to accomplish, such as price stability and maximum employment, comes second.
So it’s not clear that the Fed’s always aligned with the best interests of the economy. People don’t realize that, but it’s important to keep in mind.
Everyone knows the Fed’s raising interest rates right now. But which rates? The rate that the Fed actually raises is called the fed funds target rate. And what is that?
That’s the rate at which banks lend to each other to meet their reserve requirements on an overnight basis. Fed funds are amounts that banks lend to each other to meet overnight reserve requirements.
It’s an extremely short-term rate. The Fed targets that rate as a way to control the money supply and perhaps tweak inflation or achieve other economic goals.
The Fed Is Targeting a Rate That No Longer Exists
I don’t want to get into the mechanics of the banking system, but here’s the essential point I want to make:
There hasn’t been a real fed funds market for about 12 or 13 years, ever since the Fed began flooding the system with money during the Great Financial Crisis. Today, reserves are close to an all-time high.
In other words, the banks have excess reserves. Their actual reserves are multiple trillions of dollars in excess of the requirement. So there is no shortage of reserves.
There’s no overnight lending for reserve requirements, because all the banks have excess reserves.
So the Fed is targeting a rate that doesn’t exist anymore. Why are they doing it?
Banks aren’t lending to each other, but they are lending to the Fed in the form of excess reserves. Those are deposits at the Fed, which the Fed pays interest on. So in a sense, the interest on excess reserves is a modern substitute for the old fed funds rate.
But this money is basically sterilized. It stays within the banking system without making its way into the real economy. That’s why all the QE the Fed engaged in after 2008 never led to consumer price inflation.
The inflation we’re seeing today has nothing to do with QE (more on that in a minute). Now people say the Fed’s raising interest rates. But it’s not that simple.