In our previous article0 (How is the Fed going to keep the lid on inflation? Part 1- Losing control of the Fed Funds Rate), we discussed about how the Fed is considering using the interest rates on reserves (instead of the Fed Fund Rate) as the benchmark rate. Some observers may ask this question: with so much excess bank reserves in the financial system, how is the Fed going to drain them out of the system in order to contain price inflation?
As it turns out, the Fed has one trick up its sleeves. The jury is still out on whether this trick will work or not. We guess this trick may work in the short term, but in the long run, we have our reservations. The trick is this: increase the interest rates on the bank reserves. How will it work in theory?
You see, traditionally, the Fed did not pay interests on bank reserves. As we mentioned before in How is the Fed going to keep the lid on inflation? Part 1- Losing control of the Fed Funds Rate,
… 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.?
In the post-GFC world, the Fed pays interests on bank reserves. If you are a commercial bank, you will only lend money to someone if the returns on the loan is greater than the returns on your reserves. Therefore, the more the Fed increases the interest rates on your reserves, the less likely you will lend it out. That will result in short-term interest rates to rise.
As you can see by now, because of the dysfunction of the financial system post-GFC, the Fed Fund Rate has less and less influence on short-term interest rates. Instead, the bank reserves interest rates become a more effect control.
The question is, will the Fed’s trick work? We will talk more in the next articles. Keep in tune.
Tags: bank reserves, interest rates
