Goldman Sachs-No Fed Rate Hike Until 2012

Aside from an actual increase in the Fed Funds rate, the real number that market participants should be looking at is the interest the Fed is paying the large commercial banks to keep reserves on deposit at the Federal Reserve banks, currently 0.25%.

Depository institutions are currently holding over $1.16 trillion of reserves at the Federal Reserve banks. That compares with about $14 billion to $17 billion that banks held there merely as a reserve requirement prior to the escalation of the credit crisis in 2008.

These reserves were created when the Fed “electronically” printed dollars in order to buy assts like Mortgage Backed Securities (MBS) from the banks. The market for these securities virtually shut down in the wake of the Lehman Bros. collapse back in September of 2008 and remains almost non-existent. Currently, the Fed is holding just over $1.9 trillion of securities of which over $971 billion are MBS.

This amount of reserves being held represents about $10 trillion in potential lending that isn’t being put into the broader economy now, but it also represents a potentially huge inflationary force if the commercial banks were to resume normal lending armed with this enormous cache of reserves.

In his written testimony released last Wednesday, Fed Chairman Bernanke said that the interest on reserves tool stands a good chance of supplanting the overnight fed funds rate as the central bank’s focus in a coming tightening cycle. Instead of targeting the funds rate–currently between 0.00% and 0.25%–the Fed would raise the interest paid on reserves, thereby creating an incentive for the banks to keep a level of reserves on deposit and earning a risk-free rate of interest. Bernanke also said the Fed may set targets for bank reserve levels as well, in another departure from the current regime.

A logical question at this goes as follows: if the Fed and the government want the banks to be lending more, then why is the Fed paying interest on those reserves at this time. In other words, why is the Fed creating an incentive  for the banks to hold those reserves at the Federal Reserve banks when what they want is for the banks to circulate these funds into the economy.

The answer, in part, is because the Fed bought these securities in the absence of a market for them. What that means is that no one-not the Fed, the banks, or anyone else-knows exactly what they’re worth. And if the Fed presumably wants to sell those assets back to their original owners, then they money to buy them to have to actually be there. Still, the Fed bought these securities in order to re-liquefy these otherwise bankrupt financial institutions with the idea that at some point, normal lending would resume.

Another reason for the Fed to create this incentive is because in reality, the banks are still holding an enormous amount of losses on their books although at this time, due to the changes in accounting rules, the banks are not required to write them all down at this point. These losses are projected to continue for years to come.

For example, RealyTrac estimates that another 3 million homes will fall into foreclosure in 2010. If the average value of a mortgage is $240,000, and mortgagors typically lose about half that when a foreclosure occurs, it means that about another $360 billion of losses will happen this year on top of all the previous hundreds of billions of dollars which have already been lost.

What this means for the dollar going forward is that absent the type of crisis we’ve seen recently, it’s likely that the dollar will depreciate. That’s a big “if” though at this time because Greece in not alone; there are risks that countries like Spain, Portugal, Ttaly and perhaps Ireland will also require a level of assistance and/or auterity measures to bring their deficits in line.  There’s even the risk, although remote, that Britain itself could come under pressure.

In that case, the one sure currency bet is for dollar appreciation because as nearly always happens, when the market panics it does so by seeking out the safety of greenbacks and Treasuries.