Federal Reserve Limits Banks’ Ability to Lend

Federal Reserve building
The Federal Reserve caused an increase in cost to borrow short-term funding, which now limits banks' abilities to make cheap short-term loans.

The Fed’s plan to increase borrowing and lower U.S. interest rates has spiraled into another issue entirely. In order to pay for long-term government bonds, the Federal Reserve sold short-term funding. The short-term loan sales have increased the cost to borrow in the $5 trillion repurchase agreement and have burdened bank’s ability to accept the short-term loan debt.

The repurchase agreement, or repo, is costing banks more to fund new corporate and consumer short-term loans.  Additionally, it is increasing the cost for Real Estate Investment Trusts (REITs) to help borrowers buy homes. The Fed might intervene and try to reduce the high repo rates.

The cost to borrow repo loans have increased to 23 basis points (one hundredth of a percentage point), a significant increase from 10 basis points at the start of the year. Although the high rates provided by repo loans are financially hurting consumers and businesses, they are luring in large investors, according to UBS interest rate strategist Boris Rjavinski.

"The Fed would much rather see money market funds sponsor direct forces of credit creation to consumers and companies, but as long as repo is an attractive alternative, it’s going to siphon some of the money market funds lending capacity away from other loans," Rjavinski said to Reuters.

He also questions the Fed’s goals.

"If the Fed's intention is to provide unlimited liquidity and ensure a cheap cost of credit, elevated repo rates run counter to this goal."

But the Fed is still holding true to its plan. Eric S. Rosengren, president of the Federal Reserve Bank of Boston, said its actions are producing the expected result: lower rates on long-term loans, which can stimulate the economy. The Federal Reserve has kept the important short-term loan rate near zero for nearly four years and is expected to hold until 2015.

Although the Fed is remaining positive, Rosengren realizes that growth in the economy has been “painfully slow.”

“Given that the current inflation rate is quite low and is expected to stay low for several years, we have the flexibility to push for more improvement in labor markets,” Rosengren said to the Boston Globe. “We should continue to forcefully pursue asset purchases at least until the national unemployment rate falls below 7.25 percent and then assess the situation.”

The main concern for Rosengren is about large tax increases and spending cuts which begin in January, unless Congress can agree to reduce deficits. He worries that without a decision, a recession would be reached again.