The US Fed is looking forward at what tools are at its disposal in the future to stem the threat of inflation. Inflation fears that have been in large part fueled by the low rate environment created by the Central Bank to boost the economy out of the crisis. A low rate environment takes away the main tool that the Federal Reserve had to fight inflation and stimulate growth.
Now the C.Bank’s strategy revolves around paying interest on Bank deposited reserves. This in fact creates a rate corridor where ceiling and floor are established by the rates the Fed it is targeting.
Making interest on reserves its leading policy tool would mark yet another unexpected twist in the Fed’s response to the financial meltdown.
When the Fed pays interest on reserves, it can persuade banks to keep their money at the central bank when returns in private markets are lower.
In so doing, it can maintain a floor under the fed funds target — the rate banks charge each other for overnight loans and normally the Fed’s main tool for influencing the economy.
With interest on reserves, investors looking to the central bank for cues on monetary policy might find themselves thinking about a “policy rate” band between the rate paid on reserves and the fed funds target.
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