The rationale for the increase would seem to be the faulty logic of increasing bank reserves to increase lending -- such logic made faulty, in this case, because it's not a lack of reserves that's curtailing lending, it's a lack of trust. In the credit world, no one believes anyone anymore. The Fed realizes this, so on October 9, it began paying interest on bank reserves. Consequently, banks have shifted more of their funds into reserves, rather than lending them out. This is called "sterilizing" the reserves. It's also a free lunch for the banks.
Banks make money by charging interest on loans. With lending activity depressed, interest on loans is depressed, and the solvency of the banking system is threatened. This is one reason the Fed began sterilizing reserves: to supplement the banks' loan interest and keep the banks' cash flow intact. It's as if the Fed changed the nature of the member banks' reserves from demand deposits to savings deposits, with the latter paying interest. Since interest is a lender's profit, the Fed is providing the banks profits without risk.
But there's another reason behind its sterilization policy. The Fed is trying to avoid massive inflation, and to do that it has to avoid the money multiplier of commercial bank lending. At the same time it wants to revive lending activity. But how will it accomplish these conflicting goals?
My guess is, by becoming the world's largest commercial bank.
We need to remember the Fed is considered the lender of last resort. It can create money with the stroke of a pen or the press of a key. It doesn't need borrowers, like the commercial banks do, to create money out of thin air. The market of corporate borrowers will therefore trust the Fed because it can always avoid insolvency. So the question arises: Will the Fed begin lending directly to the market while continuing to sterilize reserves to keep banks solvent? And if so, where will it get the funds to lend? From the pool of bank reserves? From credit it creates? Both?
In effect, the commercial banks, the big ones at least, would be swallowed up by the Fed. You would be borrowing from Bank of America in name only. In truth, the loan would be managed by the Fed.
Even in 2008 this possibility seems too ludicrous to consider, but given the premises the Fed has set up, I don't see what other conclusion follows. I can't see the Fed or any central bank building up reserves to promote 100 percent reserve banking, for example, though that would be cause for celebration. Instead, it looks like the Fed is trying to solve the trust problem at the cost of high inflation, though accomplished in an unorthodox manner. The mighty Fed will do the lending, not the shaky commercial banks. Perhaps this is why the Celent report concludes:
. . . one might be excused for thinking that the frequent comparisons with the Great Depression of 1929 are not the most apt. Perhaps the economic crisis in the Weimar Republic some seven years earlier could provide a better comparison.