Why the Fed Holds but drops IOER

Posted | 02/05/2019 / Views | 4044
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In line with our article yesterday the US Fed last night lowered the IOER rate by 5bps but held their target rate at 2.25-2.5% saying it "doesn't see a strong case for a rate move in either direction". Trapped between headline strong economic growth and low unemployment against below target and weakening inflation, a weakening property market, declining earnings, poor consumer spending and growing liquidity drain from banks, they opted to stay put on the headline rate but try to force banks to lend by lowering the IOER (refer our article yesterday for an explanation of IOER).

They changed their easing language to one of holding or staying neutral and the market was expecting the more dovish former stance and so shares fell, along with gold this time as the USD took off.  Fed Chair Powell also said in the press conference afterwards they thought the declining inflation was only ‘transitory’ and hence didn’t warrant a knee jerk lowering of rates.  That comment seemingly more than any other in the actual minutes really saw markets react adversely. Remember this is a market built on stimulus so it doesn’t like such ‘good news’ that may see the cheap money disappear and higher cost of all that debt.

It’s worth reminding you now of Fractional Reserve banking.  From Investopedia: “Fractional reserve banking is a banking system in which only a fraction of bank deposits are backed by actual cash on hand and are available for withdrawal. This is done to expand the economy by freeing up capital that can be loaned out to other parties.”  In the US and here that ratio is 10%.  i.e. for every $1 they hold in reserves, they can lend $9 of newly created digital (pretend) cash.  By lowering the IOER (what the banks get on their reserves) but loaning out at the EFF (effective fed funds rate), the bank makes money and is hence incentivised to actively lend.

Fractional Reserve Banking combined with Bail-In laws are often a key motivation for people buying precious metals and crypto rather than having cash in a bank.  We saw in the Great Depression and more recently in Europe where banks have been forced to shut down as a ‘bank run’ saw too many people trying to withdraw their funds when only 1/10th of the cash needed to give to everyone is actually there.  Also as a depositor you are an unsecured creditor of the bank if the bank goes bust.  Welcome to counterparty risk 101.  Precious metals held by you or in an independent vault have no counter party risk.  None.

Whilst subtle the Fed have indeed increased cheap new money into the system as they desperately try to keep the ‘everything bubble’ from popping and get inflation to let her down easy.  Gold ultimately loves either scenario.

Case in point as Mark Moss tweeted yesterday:

“A study by the BIS [Bank for International Settlements], said one in six U.S. companies is now a zombie, meaning doesn't make enough money to even pay for the interest on its debt. Only thing keeping them alive is banks willing to extend credit, When banks suddenly deny credit, a tidal wave of companies would go BK”