NEW YORK (TheStreet) -- The Federal Reserve has strayed so far from its original mandate that its only effective policy tool, the so-called discount window, must now be used in reverse to be effective.A brief history of the Fed shows how we got to this point. The Fed was established in 1913 to act as a lender of last resort to a financial system that had been plagued with panics and the inevitable recessions that resulted since at least the Civil War. At the Fed's inception, the central bank's main policy tool was the "discount rate" and "discount window," where banks could submit eligible collateral to obtain needed liquidity when such options had dried up in the capital and financial markets. Early on, the Fed contemplated the use of Open Market Operations (OMO), the buying and selling of government securities in the open market to add or subtract liquidity from the banking system, which would affect interest rates. The first use of OMO occurred in 1922, and from that time on, until recently, that is, OMO was considered to be the Fed's main policy tool. In many of today's money and banking textbooks, you may still find such sentiment. But the era of OMO as the Fed's major policy tool ended in late 2010 with Quantitative Easing II (QE2). In 2009, as the financial system was experiencing one of those financial panics, the Fed did what it was created to do and provided liquidity to the markets where none was otherwise available. Many argue that Fed action via QE1 was instrumental in stabilizing the U.S. and world banking systems. QE1 provided the U.S. banking system with excess reserves -- reserves in excess of those required for the existing deposit levels -- of about $1 trillion. But, then, because the U.S. rebound from the recession was too slow for the Fed, in late 2010 and again in 2012, the Fed announced more QE. Today, the latest figures show excess reserves in the banking system of $2.23 trillion. The reserves required on all of today's existing deposits are $67 billion. Today's excess reserves are so massive that they can support 33 times current deposit levels without the Fed creating one more dollar. Yet with QE3, it continues to create $85 billion per month in additional excess reserves.
Excess bank reserves are called "high powered money." While they sit in an account at the Fed, they don't directly influence economic activity. But when banks lend, the newly minted money gets into the private sector and affects economic activity. And if there is no excess capacity in the labor or capital markets, inflation ensues. Just think of how much money the banks can create if their current excess reserves are 33 times more than they need. Given the magnitudes here, the use of the reserve requirement policy tool to control future bank lending doesn't appear to be feasible. So what about the use of its most powerful traditional tool, OMO? Unfortunately, the recent overuse via QE2 and QE3 has made this tool ineffective. Imagine the Fed trying to control bank lending by reducing excess reserves. It would have to sell trillions of dollars of securities into the open markets before excess reserves would become an issue for the banking system. Where would interest rates be at that point? Furthermore, long-term fiscal issues have become a real concern. With somewhere between $85 trillion and $120 trillion of unfunded liabilities rapidly approaching, huge fiscal deficits are a certainty barring entitlement, Social Security, Medicare and Medicaid reform. To keep the cost of the debt manageable within the U.S. government budget, the Fed must continue to keep interest rates low. With pressures building internationally for a different world reserve currency, foreign purchases of Treasury debt may diminish in the future. That leaves the Fed as the major lender to the Treasury via OMO purchases. Trying to reduce its holdings of securities at this time would likely result in another financial panic. Unable to use the "sell" side of OMO to influence the banking system, and unable to effectively use reserve requirements because of the magnitude of the imbalance, the Fed is now stuck with only one tool, the discount or borrowing window. Only now, because the financial system is drowning in the sea of liquidity produced by the Fed, the borrowing window and discount rate must now work in reverse. In the traditional use of the borrowing window, the Fed used the discount rate (short-term borrowing rate to encourage (by lowering rates) or discourage (by raising rates) banks from borrowing to lend to the private sector. But now because of the volume of excess reserves created by QE2 and QE3, the Fed will have to use the rate it pays, currently 0.25%/year, to the banks with excess reserves to encourage or discourage bank lending. Yes! Not the rate the banks pay to the Fed to borrow, but the rate the Fed pays to the banks to encourage them to keep their reserves instead of lending them. The original concept of the Fed as the lender of last resort has been turned on its head. Instead of the private-sector banks paying to get needed liquidity, the public sector, i.e., taxpayers, will be paying the banks not to use the excess the Fed has created. It's backward -- it's Bizarro! This article was written by an independent contributor, separate from TheStreet's regular news coverage.