The Great Fed-Financed Dollar Decline and Stock Market Rally of 2009

Published on Global, by Prof. Rodrigue Tremblay, Sept. 23, 2009.

… In fact, the Fed has broken practically every central banking rule in order to provide cheap funds to the banks. First, it has pushed the fed funds rate to close to zero so banks could have credit at close to zero cost to them. Second, it has expanded the range and quality of assets it stood ready to accept as collateral for its loans to the banks, so much so that it can be said that the U.S. Fed is presently creating new money backed by the shakiest of assets, some being called “toxic waste”. This is reminiscent of the eighteenth century (beginning in 1789) practice of the French revolutionary government of creating new money (the assignats) backed by the seized properties of the Catholic Church.

Let’s summarize quickly the numerous ways the Fed (and to a certain extent, the U.S. Treasury) have found to channel cheap funds to the banks and to brokers. In September 2008, some investment banks, such as Goldman Sachs and J.P. Morgan, officially became commercial banks in order to profit from the Fed’s new generosity: 

The last disposition is worthy of attention. Because of the easy and cheap lending to the banks, the latter piled up tremendous amounts of excess reserves at the Fed, reaching more than $700 billion. Normally, banks would quickly lend these non-interest paying excess reserves to the economy. But, in October 2008, the Fed got imaginative and obtained the authority to pay interest on the banks’ reserves, including excess reserves, at a risk-free rate (the IOER rate). Since then, the banks have been earning interest on their excess reserve holdings, and therefore had little inclination to lend those reserves out to creditworthy but nevertheless risky borrowers in the rest of the economy. With this practice, the circle has been closed, and the Fed was able to provide needed funds to the banks, at close to zero cost, and enable them to rid themselves of their bad investments, without risking creating inflation. That’s quite a banking salvage operation that will be studied by economists in detail in the future.

Indeed, it was well understood after the onset of the financial crisis in August 2007, that public capital would be needed to refinance the American banking system. Private capital was too risk adverse to do that. What was less understood was the fact that the Bush administration, and now the Obama administration that continues this policy, intended to provide this capital at close to no cost to the banks and with very scant conditions.

But who really paid and has continued to pay for this imaginative recapitalization of American banks, and who profits the most?

First of all, of course, bank profits, specially those profits by big international banks, have exploded. Bank stocks have followed suit with tremendous gains. That’s why I say the stock market rally since March 5 (2009) has been a liquidity-driven rally, engineered by the Fed. (full long text).

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