Saturday, September 12, 2009

Why You Read EPJ, Chapter 9,812

WSJ is finally reporting on the fact that the Federal Reserves hopes to control money growth by controlling the interest rate on excess reserves:

Central bankers in recent speeches have flagged a new and relatively obscure tool they believe will help them control inflation when they start winding down their unprecedented provision of liquidity to banks.

The tool is the Federal Reserve’s ability to pay interest on bank reserves held at the institution. The central bank can now compensate banks at a rate closely in line with its overnight fed funds rate target.

In theory, that makes keeping required and other reserves at the Fed an attractive option for banks. Central bankers say that power, gained last fall, allows them to get better control over the funds rate target. It also allows them to manage bank reserves more tightly, and they think it has already given them important control over prices pressures.

That’s important given the huge level of reserves banks now have after two years of extraordinary Fed liquidity provisions.

So-called excess reserves, closely watched by many inflation hawks, now stand at just under $800 billion, compared with almost negligible levels just ahead of the start of the recession. That’s in a world where the Fed’s balance sheet will likely go over $2 trillion by year end, up from around $800 billion at the start of the crisis.

If that liquidity were to flow into markets it could cause a huge inflation surge completely unwanted by policy makers. That’s why as the Fed starts to mull its eventual exit from 0% interest rates and heavy duty emergency lending, central bankers have been touting their interest paying powers as a primary tool in their bid to normalize policy.

“It’s incredibly important that they have this tool,” said Michael Feroli, an economist with J.P. Morgan Chase. It gives policy makers the breathing room to sell off their considerable store of assets at more leisurely pace, he explained.

An exit from current Fed policy lies some time away. Even so, economists believe when the Fed begins to raise rates and keeps reserves under control, it can then move more slowly to unload the considerable range of securities it has bought during the crisis. This should bring a relatively orderly unwind of all the Fed’s emergency actions....
I first suspected this months ago, in June to be specific, and I laid the whole thing out in August.

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