How is the Fed going to keep the lid on inflation? Part 1- Losing control of the Fed Funds Rate

February 7th, 2010

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Whenever we hear that the Federal Reserve is going to keep the interest rate close to zero, we may wonder what is meant by “interest rate?” Specifically, which interest rate does it mean? After all, there are many “interest rates,” from 30-day bank bill rates to 30-year Treasury bond yields. As it turns out, the “interest rate” that the Federal Reserve controls is the Fed Funds Rate.

The Fed Funds Rate is basically the rate that banks lend to each other overnight. Also, the Federal Reserve (so do many other central banks like our RBA) does not set the interest rate in the form of a decree to be followed. Instead, the Fed Funds Rate ‘sets’ the Fed Funds Rate by adjusting the supply of money such that it reaches a target that is intended (see How does a central bank ?set? interest rates?). The Fed Funds Rate in turn influences the interest rates in the market.

Well, not quite.

At least that’s true for the past two decades before the Panic of 2008. Ever since the September 2008 bankruptcy of Lehman Brothers, the Fed has lost control of the target Fed Funds Rate, as it begin to ‘print’ copious amount of money to save the world from a Greater Depression. As you may recall from How does a central bank ?set? interest rates?, the central bank can either control the quantity of money or the target Fed Funds Rate- it cannot control both. The GFC forced the Fed to flood the financial system with heaps of ‘printed’ money, which undermined its ability to control the target Fed Funds Rate.

So now the problem is to find another “interest rate” that is more relevant. As this Bloomberg article wrote,

Federal Reserve policy makers are considering adopting a new benchmark interest rate to replace the one they?ve used for the last two decades.

One of the “interest rates” that is under consideration is the interest rates paid by the Federal Reserve to commercial banks’ reserves. A simple way to understand what “reserves” are is to imagine the Federal Reserve being the bank of commercial banks. “Reserves” are simply the ‘cash’ that they ‘saved’ at the Federal Reserve.

Originally, the Federal Reserve did not pay any interests on reserves. After all, the whole point of banking is to get the banks to lend out their money to the wider economy. By not paying interest on reserves, they became unproductive assets. Thus, that prodded the banks to lend out their reserves to make their assets more ‘productive.’ As you can see by now, buying supposedly ultra-safe Treasury bonds at whatever yield was even better than keeping the reserves at the Fed at zero yield.

But the GFC messed everything up.

On October 6 2008, the Fed announced that they will be paying interests on banks’ reserves. The reason for doing so is to allow the Fed to control market interest rates and the quantity of money (reserves) via its various liquidity facilities. As the Fed said in that announcement, it

… give the Federal Reserve greater scope to use its lending programs to address conditions in credit markets [e.g. banks refusing to lend to each other] while also maintaining the federal funds rate close to the target established by the Federal Open Market Committee.

In other words, the interest rates on reserves is now the only tool at the hands of the the Fed to influence market interest rates. (Note: if you want to understand why, you can read this paper from the Federal Reserve here).

Now, there is a worry that with so much excess bank reserves (thanks to money printing) in the financial system, inflation will take hold once banks start lending them out again. What is the Fed going to do to restrain the banks from lending, thus causing inflation?

We will look into it in the next article.

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