With all the talk about the Fed possibly raising interest rates in 2010, it’s important to remember that overall Fed policy will remain expansionary for several more years at least. In fact, banks who borrow at the overnight rate are actually getting paid to borrow, a situation that is likely to persist for an “extended period” (to borrow the Fed’s phrase).

This can be seen by looking at the real (inflation adjusted) cost of funds. Remember that a real rate of return is equal to the nominal rate minus inflation. So, if a bank can borrow at a nominal rate that is below the rate of inflation (which is what’s happening now), in real terms there is a negative rate of interest.

Right now, banks can borrow at 0.25% and according to latest y/y CPI report, inflation to November was 1.8%. That means there is a -1.55% real rate of interest and that’s why banks are getting paid to borrow-in essence, they’re paying back those loans with dollars that have depreciated.

Now, with the Fed set to keep rates extraordinarily low for an extended period, even if rates work their way up to the rate of inflation (currently higher by 155 basis points), the real cost of borrowing would still only rise to zero.

Actually, the Fed could raise rates and still see the cost of borrowing become even lower for the banks. For example, let’s say the Fed adds 25 basis points to the overnight rate but that inflation increases by 30. In essence, even though nominal rates have gone up, the real cost of borrowing would of actually decreased by 5 basis points!

One member of my trade room brought up an interesting point: if banks are actually being paid to borrow, what incentive do they have to lend? The answer is very little, if any, which is why we’ve seen equity markets bounce 65% higher this year. Banks can just leverage up as they’re getting paid to use the Fed’s money to book some incredible returns in the equity markets.

Of course, this is the way the system is designed to work after the banks have taken huge hits to their balance sheets. One has to be able to walk before they can run which, the case of the banks, means they need to recapitalize in order once again be in a position to supply credit to the economy.

As far as the dollar rally we’ve seen over the past couple of weeks is concerned, the question now of course is whether the new trend can persist. What’s happening is that the market is pricing in the Fed’s next move far in advance of policy makers even giving the slightest hint they’re getting ready to move. While it’s true that the emergency facilities are being shut down, this is something that’s been in the works for months now. This week’s statement was also careful to point out that the Fed “is prepared to modify these plans if necessary to support financial stability and economic growth.”

Part of what’s also happening is that banks need to square their books for year-end accounting, a situation which demands they obtain dollars. It’s common to see the dollar rise this time of year so it won’t be until about mid January that we’ll know if indeed there is a new trend. Still, there’s plenty of room for the dollar to run and trying to catch a falling knife (or knives) can be very perilous to one’s account balance.