Why the Fed Just Decided to Give Big Banks Free Money

Janet Yellen Holds Press Conf. After Federal Reserve Meeting On Interest Rates
WASHINGTON, DC - DECEMBER 16: Federal Reserve Bank Chair Janet Yellen holds a news conference where she announced that the Fed will raise its benchmark interest rate for the first time since 2008 at the bank's Wilson Conference Center December 16, 2015 in Washington, DC. With unemployment at 5-percent and the economy showing signs of strength, the Fed raised the interest rate a quarter of a percentage point and many experts believe the interest rate on short-term loans could go as high as one percent by the end of 2016. (Photo by Chip Somodevilla/Getty Images)
Chip Somodevilla—Getty Images

The Federal Reserve decided to raise interest rates for the first time in nine years on Wednesday, and the stock market celebrated by closing up more than 200 points.

But there’s other Wall Street institutions that should love the move even more: America’s largest banks.

That’s because the Fed must use a different strategy this time around for raising rates than it normally does: Paying banks interest rates on reserves, or the equivalent of deposits that banks keep at the central bank.

On Wednesday, Fed Chair Janet Yellen announced that the bank would raise the rate it pays banks to keep reserves at the central bank from 0.25% to 0.5%. And with there being $2.5 trillion in reserves in the banking system that means that the Fed is paying America’s banks, collectively, a little more than $12.5 billion per year.

So why is the Fed paying banks so much? In normal times, the Fed is able to lower the overnight rate at which banks lend to each other by buying U.S. government debt from banks and adding to their reserves. When it wanted to raise interest rates, it would simply drain those reserves from the system, swapping those deposits for Treasuries.

But after the Fed has spent years buying up government debt of various maturities as well as mortgage-backed securities in order to drive down long-term interest rates, the banking system is awash with a huge number of excess reserves. To drain those reserves, the Fed would have to sell a good portion of those bonds. That would likely drive up interest rates—particularly long-term and mortgage rates—higher than the Fed would like. So instead of draining the reserves, the Fed has decided to pay a higher interest rate on those deposits.

This strategy enables the Fed to still control the overnight rate that banks lend to each other, because it makes no sense for them to lend to each other at a lower rate than what the Fed will pay.

And the biggest beneficiaries of these interest rate payments will be America’s largest banks, the so-called “primary dealers“, like JP Morgan, Citi, and Goldman Sachs, that act as counterparties to the Fed when it implements monetary policy. So while these unusual times may make these payments necessary, the change does underscore that it often pays well to be close to the central bank.

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