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This could turn into the mother of all interest rate margin squeezes for the banks now that the Federal Reserve has announced that for the first time in its history, it has a established a “target range” for the fed funds rate of “0 to 0.25%.” And the FOMC “anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.”

How can banks make money with an anticipated lowering of the prime rate to 3.25% when their cost of funds with any kind of intermediate term duration will likely be equal to or greater than that amount? And how will money market funds remain afloat? Once again, the Fed has demonstrated its failure to factor in all the repercussions of its actions that only cause further economic harm.

If banks lower their prime rate to 3.25% and the cost of funds for a matched book of intermediate term loans (say 5 to 7 years) would be that amount or greater, banks would be forced to support the prime rate with a drastically unmatched book. Basically, it means borrow short and lend long. This is the formula that history has taught us is disastrous: borrowing short term at extremely low interest rates that are not sustainable and loan margins turning negative as soon as the Fed needs to start fighting inflation.

Now that we understand the banks formula for failure, will there be any benefits for businesses and consumers? It is likely that banks will price loans based upon the anticipated cost of funding over the life of the loans and the credit risks of the borrowers. No matter what the Fed sets rates at, no bank will lend to a customer who can’t pay the money back - especially if they have no opportunity to sell bad loans.

The Fed voted to pay 0.25% on required and excess reserve balances held by financial institutions at the Fed, so the FOMC could have just as easily stated that they lowered the Fed funds rate 75 basis points from 1% to 0.25%. (Since there would be no reason for a bank to lend Fed funds at a price lower than it can get from the Federal Reserve itself.)

Savers and people living on a fixed income, pension plans, and insurance companies should not view this as a holiday treat from Helicopter Ben. You can’t solve the economic crisis by attempting to recreate the conditions that caused the crisis in the first place. This is why Ben Bernanke needs to go. NOW.

Source: Fed Creates Bank Margin Squeeze