In: Economics
Q: When the Fed began paying interest on excess reserves in 2009, excess reserves ballooned. Now, the old approach of buying and selling tbills will no longer have the same impact on the Fed funds rate. Brie y explain how the Fed will control the Fed funds rate from now on.
Answer:
Paying interest on reserves allowed Fed to increase the level of reserves and still maintain control of the federal funds rate. According to Fed Board's website, paying interest on excess balances should help to establish a lower bound on the federal funds rate. The payment of interest on excess reserves will permit the federal reserve to expand its balance sheet as necessary to provide the liquidity and necessary to support financial stability while implementing the monetary policy that is appropriate in the light of its systems macroeconomic objectives of maximum employment and price stability. open market Desk encountered difficulty in achieving the target for the federal funds rate set by FOMC because, the expansion of the FED's reserves various liquidity facilities has caused a huge increase in excess balances. The expansion of excess reserves in turn has placed extraordinary downward pressure on the overnight federal funds rate. Pying interest on excess resrves will better enable the desk to achieve the target for Fed funds rate.
Fed can change the rate for interest on reserves to adjust the incenties for depositary institutions to hold reserves to a level that is appropriate for monetary policy. This also provodes an important exit strategy tool, which will allow the Fed to better control the level of excess reserves when it begins to remove monetary policy stimulus.