You're Paying for This "Fake Funds" Welfare Program Right Now

Last Monday, I promised I'd tell you a little bit more about the fed funds rate. Well, the more I started writing about it, the angrier I got.

The Fed's policy of raising interest rates is a sham. We may as well call the fed funds rate the fake funds rate. The policy is the opposite of monetary tightening and actually is an easing. And the fed funds rate and all other published interest rates are based on a sham... costing you money every year if you are a U.S. taxpayer.

Here's how the scam works and what you should do about it.

How the Fed Gets Away with Padding Bank Profits

The Fed's real policy tightening, called "normalization," is where the Fed will actually withdraw money from the banking system and extinguish it. That begins this month. But meanwhile the banks and the monetary system are still awash in $2.7 trillion in excess cash. With all that cash sloshing around the system, if the market didn't believe in magic, then rates would not be moving up.

Sometimes illusions are so convincing that everyone believes they are real. This is one of those times.

The Fed pretends to raise the fed funds rate by increasing the interest it pays to banks called interest on excess reserves (IOER). It pays the same rate on reverse repos (RRP).

So-called "reserves" are deposits that the banks hold at the Fed, just like the checking accounts you and I have at our banks. The Fed pays interest on those. The Fed says that it sets the IOER rate at the top of the target range for the fed funds rate.

Here's how IOER has changed since the Fed started "raising rates" in 2015.


RRPs are overnight "loans" to the Fed. Because they expire daily, they are not much different from bank reserve deposits at the Fed. RRPs are available not just to banks, but also to mutual funds. With an RRP, the banks "lend" cash to the Fed overnight and get a bond or T-bill in return, which they then return to the Fed the next day, getting their cash back. Many participants will simply roll over this RRP, or move the cash back and forth between the RRP and their reserve deposits at the Fed.

The Fed's policy of paying interest on excess reserves (IOER) is actually a subsidy to the banks. Adding to bank profits is no way to force them to raise interest rates to their customers.

Here's a snapshot of the liability side of the Fed's weekly balance sheet report known as the H.4.1.


The line item "Other deposits held by depository institutions" is what are commonly called bank reserves, or just "reserves." They total $2.27 trillion. About $127 billion of that is required reserves. That means that $2.1 trillion are required reserves.

Reverse repurchase agreements (RRP) are in a separate line. They totaled $360 billion on Oct. 11. The sum of excess reserves and RRP is $2.46 trillion.

The Fed is paying the banks 1.25% interest on nearly $2.5 trillion. That equates to around $32 billion in subsidies to the banks per year right now. The Fed is threatening to increase that subsidy as it "normalizes" rates and the size of its balance sheet. Let's say that the Fed raises the fed funds target to 3%. That would mean it would be paying the banks $78 billion a year in subsidies. Most of that would go to Goldman Sachs, JPMorgan, Wells Fargo, Citi, and Bank of America. As if they need the U.S. taxpayers to subsidize their profits.

Historically the Fed controlled the fed funds rate by keeping bank reserves very close to zero. It added small amounts of reserves when money was too tight and economic growth was too slow. It pulled small amounts of reserves from the banks when the economy was too hot and money was too easy.

When the Fed kept the reserve base tight, banks needed to borrow reserves from one another to meet the legal reserve requirement. Those overnight borrowed funds became what are today known as fed funds. The tighter the Fed kept the reserve base, the more the banks would bid for the reserves they needed and vice versa. The fed funds rate would rise, and other interest rates would rise in sympathy.

Well, that doesn't work when the market is awash in excess cash. Healthy banks today are swimming in cash. They don't need to borrow reserves from one another to meet the reserve requirement. They are holding over 20 times the level of required reserves on balance.

The published fed funds rate looks real, and the Fed's pronouncements do impact the way money market traders think and act. But the LIBOR market - which sets the benchmark for virtually all U.S. mortgage rates and other key interest rates around the world ­- was rigged for years, and nobody outside the closed and clubby London inner circles of rate rigging knew it. It was a totally ginned up number, and now the UK financial authorities are phasing it out following the exposure of the fraud. It's a real mess.

So it goes with the fed funds rate. It's fake. No major bank needs to borrow overnight money to meet its reserve requirement when there are a few trillion of excess reserves sloshing around the banking system. All of the big banks are drowning in excess reserves.

So who is trading fed funds? What sick banks are begging for cash to meet reserve requirements? And why would a distressed bank lending rate be the basis for all other interest rates in the U.S. system? Why in the world would anyone think of this as a base market interest rate? It's akin to basing a car loan rate to an A-rated borrower on a payday loan rate quoted by loan sharks to desperate borrowers behind on paying their bookies.

Nobody would do that.

The Fed reports that about $80 billion a day is currently traded in the fed funds market. That's up from around $50 billion before the Fed started "raising rates." So it would appear that there is a small fed funds market. But today's outstanding fed funds are down from over $350 billion a day when the banks really needed to borrow reserves.

That was before the Fed started QE in 2008. QE pumped those trillions in excess reserves into the system. As it did, the fed funds market melted away to 15% of its former size. Nobody really needed to borrow reserves.


My guess is that the only trading in fed funds is by players trading the intraday arbitrage versus the rate that the Fed pays on excess reserves or reverse repos. This isn't a real market. I think that it's staged for effect by the Fed's primary dealer henchmen. Goldman and JPM and Wells and BAM are staging trades to make it appear that fed funds are a real market.

But what everybody believes is real becomes real. Other rates have moved up as the Fed has increased bank profits by paying them a free subsidy out of taxpayer pockets.

How This Sham Costs You - and What You Should Do

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That's right, if you are a U.S. taxpayer, you're paying for this sham. The Fed returns its "profit," officially called its "surplus," to the U.S. Treasury. The surplus is what's earned from the interest on the $4.5 trillion in assets it holds less expenses, such as the salaries it pays to armies of useless regulators and research economists. The Fed runs a welfare program for otherwise unemployable do-nothing regulators and academic economists who are otherwise unemployable.

After all that waste, fraud, and abuse, the Fed was returning about $2.1 billion per week to the U.S. Treasury, reducing the burden on U.S. taxpayers by that amount, or around $105 billion per year. Today, the surplus has dropped to around $1.3 billion per week, or around $65 billion per year. And that number will keep falling as the Fed raises IOER. In fact, at 3% interest rates, IOER will start to eat into Fed capital. Ultimately we taxpayers would be called on to replenish that. I suspect that the Fed will cap IOER before that happens.


In fact, as the Fed shrinks its balance sheet and takes money out of the banking system, eventually reserves will tighten and money rates will rise on their own. In the meantime the Fed will continue to maintain this illusion and the market will act as if it believes it.

So these rises in the fed funds rate and IOER actually increase bank funding. They are a form of monetary easing, not tightening. The fake funds rate is designed to convince the market that the Fed has been tightening when it really hasn't been. It has been adding small amounts of funds to the banking system ever since it began to "raise rates" at the end of 2015.

And stocks have partied on. Remember "Don't fight the Fed"? Well, the Fed has been easy throughout the rate increase period. And stocks have risen.

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But the Fed is now getting real. It has begun the program of shrinking its assets, called "normalization." The Fed will shed assets by allowing some of its holdings of Treasury notes and bonds to mature, without rolling them over. The Treasury will have to repay the Fed as the Fed redeems those notes and bonds. It will do so by selling new bonds. When investors pay for those bonds out of their checking accounts, the money will flow to the Treasury and then to the Fed in payment of the maturing bonds. The money will then literally be extinguished as it leaves the banking system and pays off the Fed's holdings.

The Fed will also allow its MBS holdings to be paid down and won't buy more MBS to replace them. That money will also disappear. Gone. Poof. The Fed will start by extinguishing $10 billion per month, which is nothing, especially given that it will be partly offset by the $3 billion per month IOER subsidy.

But the Fed will gradually increase the amount of money it extinguishes to $50 billion per month over the next year. And that's real money. It will hurt the markets.

So I continue to recommend using the current rally as an opportunity to cash out some of your stock holdings toward a goal of raising a substantial cash cushion over the next six months. The time is coming where cash will be king, and you'll be glad that you have it.

In the meantime, I will also be looking for opportunities to earn profits on the short side of the market. There will be big profit opportunities in selling short and even in buying puts, but good timing is essential. I'll alert you to some of those opportunities when not only the LAMPP, but also my technical analysis, tell us the time is right.

The time is coming. We're almost there. So stay tuned.

Urgent: Feds use obscure loophole to threaten retirees. If you have a 401(k), IRA, or any type of retirement account, this could cause you to miss out on $68,870 or more. Learn more

The post You're Paying for This "Fake Funds" Welfare Program Right Now appeared first on Lee Adler's Sure Money.

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Financial Analyst, 50-year charting expert, finance + real estate pro, and market analyst; published and edited the Wall Street Examiner since 2000.

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