The Sure-Cut Profit: How Banks Can Earn Risk-Free Money at the Expense of the Economy

The recent plunge in market-driven interest rates has left many economists and financial experts scratching their heads. Why have rates fallen so sharply, despite the Federal Reserve's efforts to stimulate economic growth? A closer examination of the Fed's current monetary policy reveals a hidden dynamic that may be contributing to this phenomenon: the sure-cut profit.

Here's how it works: banks can sell fake treasuries (i.e., securities they don't actually own) and earn a premium by promising to pay interest rates higher than what they would earn on those same securities if they were actually held in their reserves. For example, a bank could sell $1 billion worth of one-year treasuries at a 0.05% premium, earning an additional 0.05% on top of the market-driven rate of 2%. They then deposit that $1 billion at the Federal Reserve, where it earns a risk-free return of 2.35%.

This clever strategy is not unique to one-year treasuries; banks can engage in similar arbitrage schemes with two-year and other securities. The beauty of this approach lies in its simplicity: by selling fake treasuries, banks can earn a guaranteed profit without taking on any actual risk.

But what's the catch? The catch is that this strategy creates an incentive for banks to sit back and earn risk-free money at the Fed, rather than lending it to living, breathing economic actors. This means that the very institutions designed to stimulate economic growth are instead hoarding capital, waiting for the next arbitrage opportunity.

The arbitrage profit gets even better as market-driven rates fall. As interest rates decline, banks can earn an even larger premium by selling fake treasuries at a discount to their face value. This creates a self-reinforcing cycle: the more banks sell fake treasuries, the lower market-driven rates will fall, making it even easier for them to earn risk-free profits.

The Federal Reserve's current interest rate policy has created an environment that fosters this sure-cut profit. The Fed pays banks a 2.35% Interest on Excess Reserves (IOER) for deposits held above the required minimums. This rate is higher than the market-driven rates for one-year and two-year treasuries, creating an arbitrage incentive for banks to sell fake treasuries and earn the difference.

But what happens when market-driven rates fall below the IOER? That's precisely what happened shortly after the Fed crossed over its 2.35% IOER rate. The chart below shows three interest rates: the IOER, as well as market-driven rates for one-year and two-year treasuries.

As currently structured, the Fed's rate policy appears to be an active drag on the economy. By creating an arbitrage incentive for banks to hoard capital rather than lend it out, the Fed is inadvertently stifling economic growth. The only way to break this cycle is for the Fed to cut its short-term rate, making it less attractive for banks to earn risk-free profits at the expense of lending.

The implications of this dynamic are far-reaching: if left unchecked, it could lead to a prolonged period of slow economic growth and low inflation. The solution lies in the Fed's ability to recognize and adjust its monetary policy to encourage banks to lend rather than hoard capital.

In conclusion, the sure-cut profit may be just one piece of the puzzle explaining the recent plunge in market-driven interest rates. However, it highlights a critical flaw in the Fed's current rate policy: by creating an arbitrage incentive for banks to earn risk-free profits, the Fed is inadvertently stifling economic growth. It's time for the Fed to cut its short-term rate and encourage banks to lend rather than hoard capital. Only then can we expect to see a sustained recovery in the economy.

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