Magazine article Economic Trends

More Measures Introduced to Help Financial Markets

Magazine article Economic Trends

More Measures Introduced to Help Financial Markets

Article excerpt

11.06.08

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On October 8, the Federal Reserve joined with several other central banks to announce reductions in policy interest rates. The Fed's policy-making body, the Federal Open Market Committee (FOMC), voted to reduce the target for the federal funds rate to 1.5 percent. The Bank of Canada, the Bank of England, the European Central Bank, the Sveriges Riksbank, and the Swiss National Bank also reduced interest rates. The FOMC's statement for this intermeeting move noted that "incoming economic data suggest that the pace of economic activity has slowed markedly in recent months. Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit."

At its next meeting on October 28 and 29, the FOMC unanimously decided to again reduce the target for the federal funds rate by 50 basis points, bringing it to 1 percent. In its statement, the FOMC stated that "recent policy actions, including today's rate reduction, coordinated interest rate cuts by central banks, extraordinary liquidity measures, and official steps to strengthen financial systems, should help over time to improve credit conditions and promote a return to moderate economic growth."

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On October 6, the Federal Reserve announced that it will pay interest on depository institutions' required and excess reserves. This change had been planned and was scheduled to go into effect in 2011, but the Emergency Economic Stabilization Act of 2008 accelerated the effective date to October 1, 2008. The rate paid on required reserves was set to the federal funds rate target minus 10 basis points. The Federal Reserve statement explains that "paying interest on required reserve balances should essentially eliminate the opportunity cost of holding required reserves, promoting efficiency in the banking sector." The rate on balances in excess of those required was set to the federal funds rate target minus 75 basis points.

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An advantage to paying interest on excess reserves is that it is expected to make it easier for the Federal Reserve to keep the effective federal funds rate close to the target rate. During times of financial stress, the effective funds rate has fallen below the target funds rate. The idea behind the new approach is that if banks can earn interest on excess reserves, the funds rate should always remain above the rate paid on those reserves. Presumably, whenever the effective federal funds rate falls below the interest rate that banks can earn on excess reserves, they would have an incentive to borrow at the funds rate and park the cash in reserves. This "arbitrage" opportunity would put upward pressure on the funds rate until the effective funds rate was at least as great as the interest rate earned on excess reserves.

For reasons not well understood, even after interest began to be paid on reserves, the effective funds rate still traded below the rate on excess reserves. Nevertheless, on October 22, the Federal Reserve announced an alteration to the formula for interest paid on excess reserves. Instead of subtracting 75 basis points from the target of the federal funds rate, the new formula subtracts only 35 basis points. The Board explained this decision, stating 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. …

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