07 Oct 2008

Fed Uses New Power to Engineer a "Stealth Cut" in Interest Rates

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Amongst its weaponry, the government just got fear, surprise, ruthless efficiency, and an almost fanatical devotion to low interest rates–namely, the ability to pay interest on reserves kept at the Fed.

I have been puzzling over this ever since it was announced. It seems innocuous enough; at worst, I thought it just gave the Fed one fewer restraint in pumping in excess “liquidity.” (Without being able to pay interest, if the Fed pumped in too much extra reserves, then the federal funds rate might drop below the target. This is because the banks would have an incentive to lend out any excess reserves and earn something on them, rather than parking them on deposit with the Fed and earn 0%.)

Well, no sooner had the Fed gotten its wish than it engineered a “stealth” (the press’ word, not mine) rate cut. By paying an interest rate on balances kept at the Fed, the central bank can set a floor below which no bank would ever lend out to another bank. But, by setting this floor 75 basis points beneath the current, official target of 2%, the Fed can “cut rates” without actually announcing this to the world. (HT2 Bill Barnett.)

Now, at first this seems like something the Fed could have done all along. I.e., the Fed could have decided its “real” target was 1.25%, and then just pumped in enough extra reserves to cause the market-determined federal funds rate to sink to that level. However, I think the added twist here, is that there is something fairly objective that the banks can see. In other words, the Fed can objectively set the interest rate that it pays on bank balances, and all insiders can see and verify this fact. In contrast, before this new power, if the Fed did a stealth rate cut, the banks would have to just play mind games and try to guess what the true rate was, since all they would have to go on would be the official target rate and then the Fed’s handling of reserves.

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