The effective fed funds rate is getting close to 0%; the Fed raises interest on reserves

Wednesday, October 22, 2008

Today, the Federal Reserve announced that it would increase the interest paid on bank excess reserves that are held on the Fed's balance sheet. The rate rises from the lowest FOMC target rate minus 0.75% to the lowest FOMC target rate minus 0.35% (target minus 0.35%, which is 1.15%), an increase of 40 basis points.

The Federal Reserve began paying interest on excess reserve balances on October 6 in an effort to maintain a lower bound on the effective federal funds rate, which was trading well below target following the Fed’s unprecedented liquidity measures over the last month.

By paying interest on excess reserves, the Fed increases the incentive for a bank to hold excess reserves with the Fed. This reduces the amount of interbank lending, and and increases the effective federal funds rate. The move, in theory, sets a lower bound on the effective federal funds rate.

Apparently the Fed was not paying enough reserve interest because the effective rate has been trading low, 0.67%, which is well-below the Fed’s target, currently 1.5%. The increased interest payments on excess reserves should increase the reserves held with the Fed, and drive up the effective federal funds rate. However, this is a new policy tool, and the correct rate still needs to be hammered out by the FOMC.

According to Bloomberg, Ben Bernanke said this about the policy measure:
“We're not quite sure what we have to pay in order to get the market rate, which includes some credit risk, up to the target,'' Bernanke told economists Oct. 7. ``We're going to experiment with this and try to find what the right spread is.'
RW: Hopefully they get it right because the current level of the effective rate doesn't leave a lot of room for an expansionary rate cut at the FOMC's next meeting.

Rebecca Wilder


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