Are Big Banks Gaming the Federal Reserve at the Expense of American Citizens?

Last week Minneapolis Federal Reserve Bank President, Narayana Kocherlakota dissented from the decision made by the Federal Open Market Committee to change its language regarding interest rates. He was also joined by Dallas Fed President Richard Fisher and Philadelphia Fed President Charles Plosser. The following day Narayana Kocherlakota issued a statement detailing the reasoning behind his dissent stating:

I believe that in November, the Committee judiciously chose a level of accommodation that was well calibrated for the prevailing economic conditions. Since November, inflation has risen and unemployment has fallen. I do not believe that providing more accommodation—easing monetary policy—is the appropriate response to these changes in the economy.” (Emphasis mine.)

While this is statement is a step in the right direction, and one we’ve been advocating for quite some time, here is a better reason for dissent:

2 year swaps chart

This is a two-month chart of 5-year interest rate swaps. Notice the big jump in price on August 9th followed by the spike in volume (contracts traded) the next day on August 10th. Notice also the run-up into the FOMC’s meeting that took place on August 9th. These large moves and transactions are not being conducted by your average trader or the neighbor across the street. These are big banks and institutions using Federal Reserve loans to initiate carry trades. This is primary dealers with the Fed borrowing cash for free and then pumping them into short-term treasuries and other highly-rated debt and collecting the spread. Right now that’s between 1% and 2% depending on the trade.

When the Fed changed their “extended period” language to say instead that it “currently anticipates economic conditions … are likely to warrant extraordinarily low levels of the federal funds rate through mid-2013,” it gave the green light to banks to put on these trades risk-free for another two years. This is money that should be going to businesses in the form of loans and investment to get a real recovery started. Instead it’s just being parked in the wonderfully transparent world of high finance producing profits for those lucky enough to be anointed the ability to borrow Fed dollars interest-free.

James Groth is a research associate at Reason Foundation, a nonprofit think tank advancing free minds and free markets. Prior to joining Reason, where he works on monetary policy reform and financial regulation, he worked as a proprietary trader and asset manager. Groth holds a B.A. in economics from Tufts University.