Wednesday, 22 October, 2008
The Federal Reserve will raise the interest rate it pays banks for the excess cash they keep on deposit so it can keep pumping funds into the financial system without affecting the central bank's monetary policy.
Fed officials acted after the initial rate they set Oct. 6 failed to keep the benchmark U.S. overnight interest rate close to the target set by policy makers. The central bank will pay interest on excess reserves at the lowest target rate for a one- or two-week period less 0.35 percentage points, effective tomorrow, the Fed said in a statement.
The previous rate was 0.75 percentage point below the target. Chairman Ben S. Bernanke wants to ensure that his efforts to flood the financial system with cash don't interfere with the policy rate. The Fed started paying interest on reserves this month after gaining authorization under the financial-rescue bill passed by Congress.
`We're not quite sure what we have to pay in order to get the market rate, which includes some credit risk, up to the target,'' Bernanke told economists Oct. 7. ``We're going to experiment with this and try to find what the right spread is.''
Fed governors ``judged that a narrower spread between the target funds rate and the rate on excess balances at this time would help foster trading in the funds market at rates closer to the target rate,'' the Fed said today in Washington. Officials will ``make further adjustments as needed.''
`Floor' On Rate
The goal of paying interest on reserves is to set a ``floor'' under the federal funds rate on overnight loans between banks, Bernanke and other economists have said. The policy allows the Fed to pump more cash and loans into the financial system without worrying the rate will drop to zero at the end of each day as banks withdraw excess reserves.
A higher rate on payments may give banks too much of an incentive to keep funds at the central bank rather than lend them out.
The federal funds rate traded as low as 0.25 percent this week and 0.13 percent last week, compared with the 0.75 percent rate the Fed pays on reserves. The Fed didn't immediately have an explanation for why the rate was trading below the supposed floor. Fed officials cut their target for the benchmark rate by a half point to 1.5 percent on Oct. 8.
``We've fallen through the floor,'' said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York.
Close to Target
The Fed's outstanding cash loans to banks and other financial institutions totaled about $730 billion last week, compared with almost nothing a year ago. Before gaining the power to pay interest, the central bank kept the federal funds rate close to the target by buying and selling Treasuries on the open market to add or withdraw funds from the banking system.
`The Fed is just trying to bring the funds rate closer to the target rate given the massive amount of liquidity that is out there,'' said John Ryding, founder and chief economist of RDQ Economics LLC in New York and a former Fed researcher.
The Fed requires banks to keep a level of reserves at the central bank. On those funds, the Fed pays a higher rate equal to the average target rate over a one or two-week period less 0.10 percentage point. That rate was unchanged today, while the Fed raised the rate on excess reserves that are above the required levels.
Source: http://www.bloomberg.com/