Tuesday, October 7, 2008

Bernanke Confirms Ramifications Of Fed's New Ability To Pay Interest On Bank Reserves

In a speech today before the National Association for Business Economics 50th Annual Meeting in Washington, D.C., Fed Chairman Bernanke confirmed my earlier analysis today of the ramifications of the Fed's new ability to pay interest on bank reserves. From Bernanke's speech today:

The Federal Reserve has also been granted a new authority, the ability to pay interest on bank reserves, which will allow us to expand our lending as needed to support the system while better managing the federal funds rate...

The expansion of Federal Reserve lending is helping financial firms cope with reduced access to their usual sources of funding. Recently, however, our liquidity provision had begun to run ahead of our ability to absorb excess reserves held by the banking system, leading the effective funds rate, on many days, to fall below the target set by the Federal Open Market Committee. This problem has largely been addressed by a provision of the legislation the Congress passed last week, which gives the Federal Reserve the authority to pay interest on balances that depository institutions hold in their accounts at the Federal Reserve Banks. The Federal Reserve announced yesterday that it will pay interest on required reserve balances at 10 basis points below the target federal funds rate, and pay interest on excess reserves, initially at 75 basis points below the target. Paying interest on reserves should allow us to better control the federal funds rate, as banks are unlikely to lend overnight balances at a rate lower than they can receive from the Fed; thus, the payment of interest on reserves should set a floor for the funds rate over the day. With this step, our lending facilities may be more easily expanded as necessary.

Bottom line, the ability to pay interest on reserves is a new highly powerful tool for the Fed to use. It will result in the Fed having the ability to increase reserves without necessarily changing the Fed Funds rate. This is not a taser gun, it is a bazooka--and has the potential to be a very inflationary tool.

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