Raymond James’ Dr. Brown: Explaining the Fed’s exit strategy

The target for the federal funds rate (the overnight market rate that banks charge each other for borrowing excess reserves) has, since 1994, been the main monetary policy tool for the Federal Reserve.

The following is an analysis by Scott J. Brown, senior vice president and chief economist at Raymond James & Associates, of Fed Chairman Ben Bernanke’s announcement on February 10, 2010.

The target for the federal funds rate (the overnight market rate that banks charge each other for borrowing excess reserves) has, since 1994, been the main monetary policy tool for the Federal Reserve.

The discount rate (the rate that the Fed charges banks for short-term borrowing) had been the main policy tool before 1994. The Fed began paying interest on required reserves and on excess reserves in October 2008.

In the federal funds market, the quantity of reserves demanded is a decreasing function of the federal funds rate (FFR). There is a reserve requirement (banks have to hold a certain percentage of deposits in the form of reserves) and the demand for excess reserves is a form of insurance.
However, the federal funds rate should not go below the interest rate the Fed pays on excess reserves (IER) – since a bank could lend excess reserves to the Fed. This results in a kink in the demand curve. The quantity of reserves supplied is determined by the Fed, but the federal funds rate should not go above the discount rate (DR) – since banks can borrow from the Fed at the discount rate, they won’t pay more to borrow from other banks.

Once the Fed begins to tighten policy, it will drain reserves. It can do this by selling assets, but the federal would perhaps have to sell an unsettlingly large amount of assets to push the supply curve past the kink in the demand curve.

So the Fed funds rate, in this scenario, would not be a reliable measure of monetary policy. While the Fed is reducing bank reserves (by selling assets at a gradual pace), it can also raise the interest rate it pays on excess reserves.

Eventually, the supply curve will pass through the kink and the Fed can again rely on the federal funds target rate (r*) as the main tool of monetary policy. In normal conditions, the federal funds target rate will be somewhere between the interest paid on excess reserves and the discount rate.

Until then, the key monetary policy tools will be the interest rate paid on reserves and the target level of bank reserves. Currently, the federal funds target rate is 0% to 0.25%, the interest paid on excess reserves is 0.25%, and the discount rate is 0.5%. “Before long,” Bernanke says, the Fed will raise the discount rate.

However, he adds that this should be viewed as part of the normalization of the Fed’s lending facilities – not a tightening of credit to consumers and businesses.

For more commentaries by Dr. Brown, go to raymondjames.com/monit1.htm.