The End of Easy Money

In his testimony before Congress today Federal Reserve Chairman Ben Bernanke gave a clear indication that his bank is to begin tightening monetary policy in the near future. His testimony gave a number of actions the bank is preparing to take to remove the liquidity it has created over the last few years. Once the bank begins taking its actions, such as raising the interest rate it pays on excess bank reserves along with its discount and federal funds rates, loan markets will quickly follow with higher demanded rates on all loans from corporate credit to federal debt. While these actions are necessary to stem any inflationary effects that may begin to creep into the system due to the flood of money in the last two years, they may be ill timed with the fledgling economic recovery and planned increase in government borrowing.

Though Bernanke only described the banks options as something they were beginning to consider, markets likely will not wait for action to price in higher interest rates. Any effects that are going to be felt will likely be felt much sooner than the Fed is predicting. A rise in any and all rates over the coming weeks is increasingly likely along with their associated effects on the financial sector as a whole.

Such a move might also have an impact on the government's upcoming fiscal plans. There have been recent rumors of a third stimulus or 'jobs' bill along with a proposed FY 2011 budget. All of these plans have have included a large amount of new Federal debt issuance. There were a number of relatively conservative estimates of the cost to service this debt in the budget proposal. Should interest rates rise, this debt will become increasingly expensive which may endanger the passage of such spending proposals. The government would be given three uncomfortable choices: spend less, pay more or tax more.

On a small side note, there might be an interesting arbitrage opportunity for institutions with access to the Federal Reserve system. The Fed currently is paying a 0.25% rate on excess deposits within its system while maintaining a overnight Fed Funds rate of 0.00-0.25%. There might be opportunities for banks to bet on a rise in the Fed's interest paying rate by taking longer term loans from the Fed system at any amounts up to 0.25% and holding them as excess deposits. Should the Fed then pay a higher rate of interest at anytime, that bank could essentially have a free 0.25% spread for the term of its loan.