The Federal Reserve’s main weapon for curbing inflation is simple; Banks will be paid risk-free interest not to lend, and instead keep their money at the Fed. So our current shovels of cash to banks are supposedly to encourage lending. When it’s time to hit the brakes, they will get paid not to lend. Mr. Bernanke outlined the plan in his recent WSJ editorial:

Congress granted us authority last fall to pay interest on balances held by banks at the Fed. Currently, we pay banks an interest rate of 0.25%. When the time comes to tighten policy, we can raise the rate paid on reserve balances as we increase our target for the federal funds rate. Banks generally will not lend funds in the money market at an interest rate lower than the rate they can earn risk-free at the Federal Reserve.

Yes, that should dampen inflationary pressures. But it’s a true perversion of justice that banks will once again profit from the mess they created. If asked why banks should reap even more gains from their mess and rescue, Big Ben would probably voice his distaste for this “necessary evil”, adding that he is “as unhappy about it as anyone, but we have no choice.”

Currently, lawmakers and The Fed are trying desperately to increase lending, providing banks with cheap cash and threatening them with legislation if they don’t. So when the time comes to tighten, the plan is essentially to bribe lenders with risk-free interest as a reward for tightening their belts. Starting to see a pattern emerge? No matter the economic environment, banks get rewarded.

Alternative Inflation Curbs?

Couldn’t the Fed get the same result by increasing banks’ reserve requirements? Why not force banks to hold bigger cash “cushions” in the form of more vault cash and higher TCE ratios? The result should be be the same as paying banks not to lend – tighter money, less lending, and lower inflation. The difference is that it wouldn’t be profitable for banks. The same ones who essentially own the Fed. After all, if we’ve learned one thing from this little collapse, it’s that bank profits are the most important step towards recovery. That seems to be the attitude of Larry Summers and Tim Geithner, anyway.

Related: MarketSkeptics.com has a nice report on reserve requirements here. The chart below shows just how tiny (or non-existant) bank cushions have become: