If Americans (or other citizens) ever hope to regain some semblance of control over their monetary system, they must be able to clearly understand exactly how the federal reserve system functions and its destructive potential. People must understand that, in times of 'loose' monetary policy, 'setting a target federal funds rate' can be more accurately characterized as effectively 'printing and giving away enough money to provide subsidization for unnaturally low lending and borrowing rates'.
Further, when the Fed engages in sustained low interest rate targeting, this is akin to an "all-clear" signal to the larger member-banks that now is the time to load up on Treasuries and other useless assets that the Fed mindlessly pays cash for to achieve policy goals. This effect is especially pronounced in the midst of a struggling economy, when banks can be more certain that the Fed will be under intense pressure to maintain rock-bottom interest rates. Talk about moral hazard.
If primary dealers can clearly gauge the extent of the Fed's interest in maintaining abnormal levels of liquidity (such as during a financial crisis or struggling economy), they can increase their demand for both risk assets and Treasuries accordingly to benefit from the imminent Fed action. Seeing a higher federal funds rate as a result of irresponsible lending and leverage, the Fed will be obliged to purchase over-valued Treasuries from the primary dealers thereby rewarding them! If the Primary Dealers predict the action of the Fed (which is based on their own irrational action), they will make a lot of profit. Even when the Fed uses a reverse-auction mechanism to buy the Treasuries, the total demand for Treasuries has risen to an unnatural level in the described scenario. The difference between the value of Treasuries that could be sold naturally and the value of Treasuries actually sold is the amount of monetary inflation created.
There are currently 18 primary dealers in the US, and each one has the capacity to manipulate the federal funds rate at will. The more that these banks are able to borrow from each other and "invest" in anything from subprime mortgages to Pets.com, the more that the federal funds rate is likely to spike and induce further Fed intervention (read: free money!) Member-bankers are able to leverage themselves to their eyeballs, investing in whatever garbage comes across their desks and, as long as the "assets" invested in are of sufficiently large duration, they will continue to be highly profitable for a long while as the Fed diligently prints money and floods the system with artificial liquidity incited by the excessive risk-taking.
But don't take my word for it, look what the Fed themselves have to say in their publication entitled `The Federal Reserve System: Purposes and Functions`:
During most of the 1970s, the Federal Reserve targeted the price of Federal Reserve balances. The FOMC would choose a target federal funds rate that it thought would be consistent with its objective for M1 growth over short intervals of time. The funds-rate target would be raised or lowered if M1 growth significantly exceeded or fell short of the desired rate. At times, large rate movements were needed to bring money growth back in line with the target, but the extent of the necessary policy adjustment was not always gauged accurately. Moreover, there appears to have been some reluctance to permit substantial variation in the funds rate. As a result, the FOMC did not have great success in combating the increase in inflationary pressures that resulted from oil-price shocks and excessive money growth over the decade.
In other words, once the Fed had decided to target interest rates on reserves, the Banks were off to the races with their lending and borrowing activities and counting on the Fed to continue a policy of rate suppression (i.e., conduct open market purchases to keep rates low, essentially giving out free cash and replenished reserves in exchange for already bidded-up Treasuries). The Fed told the banks: "Don't lend unscrupulously, or else I will continue to buy your inventory of overpriced junk with freshly printed coin. Oh, and I'll make sure interest rates are tantalizingly low for you." What is a prudent bank to do but to go bananas? The bankers' response? "Sure, our loans may not perform over decades, but imagine all the free money we will be inciting once the Fed reacts! And interest rates are so low it's practically a steal!"
Of course, until the unexpected Mr. Paul 'the Party Pooper' Volker stepped in at least.
By late 1979, the FOMC recognized that a change in tactics was necessary. In October, the Federal Reserve began to target the quantity of reserves—the sum of balances at the Federal Reserve and cash in the vaults of depository institutions that is used to meet reserve requirements—to achieve greater control over M1 and bring down inflation. In particular, the operational objective for open market operations was a specific level of nonborrowed reserves, or total reserves less the quantity of discount window borrowing. A predetermined target path for nonborrowed reserves was based on the FOMC’s objectives for M1. If M1 grew faster than the objective, required reserves, which were linked to M1 through the required reserve ratios, would expand more quickly than nonborrowed reserves. With the fixed supply of nonborrowed reserves falling short of demand, banks would bid up the federal funds rate, sometimes sharply. The rise in short-term interest rates would eventually damp M1 growth, and M1 would be brought back toward its targeted path.
In other words, the bankers, desiring to incite the Federal Reserve into flooding the system with ever-increasing liquidity, had tried their damndest to manipulate the federal funds rate and get the Federal Reserve to cave in and further debase the currency. However, the Federal Reserve academics had learned their lesson! They would simply allow the interest rate to spike and wait for the bankers to slow down their demand for borrowing once they realized they could not cause the Fed to budge. After admitting defeat in this battle, do the bankers go back to the drawing board? Is the Pope Catholic?
By late 1982, it had become clear that the combination of interest rate deregulation and financial innovation had weakened the historical link between M1 and the economic objectives of monetary policy.
Translation: bankers realized that they could indirectly influence the price of credit by "innovating" new and unconventional sources of funding such as swaps, repos and other goodies. These new channels for leverage made the Fed sit up and take note:
The FOMC began to make more discretionary decisions about money market conditions, using a wider array of economic and financial variables to judge the need for adjustments in short-term interest rates.
Check mate! Or...
Beginning in the mid-1980s, spreading doubts about the financial health of some depository institutions led to an increasing reluctance on the part of many institutions to borrow at the discount window, thus weakening the link between borrowing and the federal funds rate. Consequently, the Federal Reserve increasingly sought to attain a specific level of the federal funds rate rather than a targeted amount of borrowed reserves. In July 1995, the FOMC began to announce its target for the federal funds rate.
In a circular turn of events, we end up at the original strategy we discussed, with the only caveat being that the bankers now have complete awareness as to what is in store. Bravo, Fed. Bravo.
And once the bad lending finally caught up with the banks and they started taking massive write-downs, what better way to make sure the Fed keeps interest rates abnormally supressed than for the TBTF banks to engineer a global financial crisis. Especially since the Fed now takes "a wider array of economic and financial variables" into account when deciding monetary policy.
Of course, as the Fed does not disclose the details of its operations, all of this is pure speculation.