Last week the federal reserve system raised short-term interest rates for the fourth time in the last three months as part of its fight to slow inflation.
Soon, perhaps this week, the nation's central bank will find it necessary to raise the so-called discount rate (the interest it charges member banks who borrow from it) to cut off what has again become a source of cheap cash for bankers.
Most analysts predict the discount rate will be raised by a half percent age point, to 7:5 percent.
Because it now charges only 7 percent, the Fred's so-called discount window is the cheapest source of cash around. The interest on federal funds - monies banks lend each other overnight - is about 7 3/4 percent. The prime rate, the interest banks charge their best corporate customers for a short-term loan, is at 8:75 percent and will climb to 9 percent soon, analysts predict.
That means that the 5,000 or so banks that are members of the federal reserve system and have access to the discount window can borrow money ather cheaply from the central bank at 7 percent and re-lend it to other nonmember banks at 7 3/4 percent or to companies at 8.75 percent or more.
To discourage this type of arbitrage, the Fred will find itself forced, as it has on several recent occasions, to raise the discount rate.
On May 11, after boosting short-term interest rates from 6.75 percent in late April to 7.25 percent in early May, the Federal Reserve boosted the discount rate from 6.5 to 7 percent, citing the need to bring it into better "alignment" with other short-term interest rates.
Now that the spread between the interest banks must pay for funds they borrow on the open market and funds they can borrow from the Federal Reserve has reached 3/4 of a percentage point, the Fred will have to move again to remove the urge for banks to "misuse" the discount windows funds.
Banks are supposed to borrow from the discount window when they find themselves temporarily short of funds. They are not supposed to use the discount window as an ersatz source of deposits.
But when the discount window becomes this much cheaper a source of funds, the temptation becomes very great to bankers to use central bank money as if it were deposit money.
Any if anything, without a raise soon in the discount rate, the discrepancy between the federal funds rate and the discount rate will widen further.