In October 2008, Congress granted the Fed power to pay interest on both required and excess reserves for the first time. Before then, the Fed never paid any interest on bank reserves. After the WesCorp and US Central debacles and the resulting required shift towards safer and lower yielding investments, it's unclear how the corporate credit unions can continue to compete with the Federal Reserve. A handful of credit unions have already made the jump from a corporate to the Fed.
This new policy is a game changer. Before, the Fed could only raise interest rates by making reserves scarce relative to demand. This was done by "open market sales," or selling government bonds and debiting the reserve accounts of banks. The reduction in the supply of reserves sent the interest rate on reserves upward. That is how the Fed controlled the interest rate on the all-important Federal Funds Market, the market for overnight reserves that the banks lend each other to satisfy both the Fed's reserves requirements and their own liquidity needs.
Now the Fed can maintain a large quantity of reserves to satisfy the banks' desire for liquidity and still fight inflation by simply raising the interest rate that its pays on reserves without removing. The interest rate must set the floor to the Federal Funds and other short-term rates since no financial institution would loan out reserves in the Fed Funds market at a lower rate than they can receive on deposit from the central bank. The Fed can now raise rates and maintain the liquidity of our banking system.
(Derived from yahoofinance.com article)
This new policy is a game changer. Before, the Fed could only raise interest rates by making reserves scarce relative to demand. This was done by "open market sales," or selling government bonds and debiting the reserve accounts of banks. The reduction in the supply of reserves sent the interest rate on reserves upward. That is how the Fed controlled the interest rate on the all-important Federal Funds Market, the market for overnight reserves that the banks lend each other to satisfy both the Fed's reserves requirements and their own liquidity needs.
Now the Fed can maintain a large quantity of reserves to satisfy the banks' desire for liquidity and still fight inflation by simply raising the interest rate that its pays on reserves without removing. The interest rate must set the floor to the Federal Funds and other short-term rates since no financial institution would loan out reserves in the Fed Funds market at a lower rate than they can receive on deposit from the central bank. The Fed can now raise rates and maintain the liquidity of our banking system.
(Derived from yahoofinance.com article)
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