So the US economy is starting to look shaky. What’s the Fed to do? With short-term interest rates already at rock bottom, over the summer the Fed started wading into the Treasury market to keep longer-term interest rates down. The more gloomy the outlook gets for the economy, the more likely it becomes that the Fed will make a big plunge into the Treasury market to really get longer term rates down. But that could easily backfire, having the unintended consequence of discouraging banks from lending more to households and businesses.
Although most banks are on the mend, they still don’t have a lot going for them. Sure, some business lines are doing alright, but their main act of lending to consumers and companies is lousy. Luckily for them, they can borrow at rock bottom short-term interest rates and turn around and lend it longer-term and risk-free to the government and its cohorts, earning a juicy spread in the process. It’s good business if you can get.
But if the Fed really starts buying Treasuries again big time and longer term interest rates come down, then there goes the banks nice little earner. If the banks lose a main source of juicy, low-risk income are they going to want to take the risk of rushing out and start lending to everybody or are they going to buckle up and sit tight? There’s a real chance the banks will sit tight.
The sad fact is that the Fed has precious few options left — if any — to help revive the economy.
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