Wednesday, November 5, 2008

More Excess Reserve Buildup Ahead

Bloomberg reported yesterday that the Federal Reserve is encouraging more hoarding of excess reserves by banks shoring up its efforts to "sterilize" its injections of liquidity to the banking system:
Nov. 5 (Bloomberg) -- The Federal Reserve boosted the interest rate it pays banks for the excess cash they keep on deposit, aiming to prevent its record injection of funds into the financial system from affecting its monetary policy.

``The rate on excess balances will be set equal to the lowest Federal Open Market Committee target rate in effect during the reserve maintenance period,'' the Fed said in a statement. The federal funds target stands at 1 percent.
The WSJ's RTE blog also noted this development and reported the Federal Reserve believes this move "would help foster trading in the funds market at rates closer to the FOMC’s target federal funds rate." In response, a perplexed reader named "confused" left the following comment at the RTE blog:
Why? The entire point to flooding the market with liquidity was to get inter-bank and bank-corporation lending started again. If that leads to a traded fed-fund rate less than the target rate, that just means the excess liquidity still needs time to work. This move seems to completely negate the prior efforts. I ask again: why???
Great question from "confused." Here are my thoughts on this matter.

Update: A reader in the comments section directs us to FT.com/Alphaville where Sam Jones provides further insight on this development. He argues we are in a liquidity trap, the Fed now recognizes it , and as a result it may cut back on sterilizing its liquidity injections. I hope Sam is correct. What do you think?

3 comments:

  1. David, we're glad you are back blogging, we thought you'd given up in frustration at the Fed's bizzaro world policies.
    Here is the Financial Times take:
    http://v2.ftalphaville.ft.com/blog/2008/11/06/17903/fed-capitulates-the-central-bank-is-broken/

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  2. Anonymous:

    Thanks for the link. Sam Jones had some interesting points to make. I will try to check him out more regularly. I used his post in an update.

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  3. And perhaps now a solution to what is going on from Jim Hamilton?

    He talks about the institutional factors underlying the Fed's actions, but the bottom line is
    this:
    "the target itself has become largely irrelevant as an instrument of monetary policy, and discussions of "will the Fed cut further" and the "zero interest rate lower bound" are off the mark. There's surely no benefit whatever to trying to achieve an even lower value for the effective fed funds rate. On the contrary, what we would really like to see at the moment is an increase in the short-term T-bill rate and traded fed funds rate, the current low rates being symptomatic of a greatly depressed economy, high risk premia, and prospect for deflation.

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