Tuesday, October 7, 2008

Excellent discussion of likely Fed policy

By Tim Duy, via the Economist's View
It is impossible to rule out a rate cut, and it seems like a cut should be the baseline case. Indeed, the case for a rate cut should be a slam dunk, expect for a.) rates are already low and b.) we haven’t seen a rate cut yet. ... The Fed may simply have already moved well beyond rate cuts in searching for solutions to the current crisis. And outright asset purchases is looking like that next move.
Paying interest on reserves (banks' deposits at the Fed) puts a floor on the Fed Funds rate. Suppose, as is the case, that the Fed flooded the market with liquidity (through the TAF, temporary auction facilities - which, now that there's an actual schedule, don't look too temporary). The increase in the supply of excess reserves should lower the Fed Funds rate, say from 2% to 1.5% But if the Fed keeps the interest rate to be paid on deposits at the Fed at, say, 2%, then those excess reserves will be borrowed at 1.5% and flow back into the Fed, as deposits, at 2% - this will keep going on until the Fed Funds rate returns to 2%.

So why do this? The problem of the TAF is that it provides liquidity a little too broadly. Not every institution that gets liquidity needs it equally badly. Suppose an institution that doesn't need liquidity gets it: since it didn't need it to pay its liabilities, and since keeping it as excess reserves earns income, the institution will "park" the excess reserves at the Fed, effectively "mopping up" the excess liquidity. Suppose an institution does need liquidity. It will use it to pay its depositors, suppliers, employees, creditors, etc., because its need for liquidity will exceed the interest on the Fed's deposits. So we get a happy situation in which the people that spend the Fed's cheap cash are the people who actually need it.

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