The Fed Raises Rates—by Paying the Banks

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BY MARTY WOLFSON | JANUARY/FEBRUARY 2016


The business and financial press has been abuzz with speculation about when the Federal Reserve would begin raising interest rates. After the meeting of its Federal Open Market Committee (FOMC) on December 15-16, the Fed ended the suspense by announcing that it was raising its target federal funds rate by a quarter of a percentage point (to a range of 0.25 to 0.50%). Flying under the radar, though, was the Fed’s use of a dramatically different method of raising interest rates. The new method involves paying billions of dollars to banks, primarily by paying interest on banks’ reserves held at the Fed. The payments will reduce the amount of money that the Fed remits to the Treasury and, ultimately, to taxpayers.

Why Is the Fed Paying the Banks?

This new method is best understood when viewed in the context of the recent financial crisis. The collapse of the housing bubble in 2007 threatened both the financial system and the broader economy. The Federal Reserve began a campaign of aggressively reducing interest rates, lowering the interest rate that it controls, the federal funds rate, from its peak of 5.25% in September 2007 to just 2% in April 2008. The federal funds rate is an interest rate that banks pay when borrowing from other banks. Lower costs for the banks in turn lead to lower interest rates for business and consumer borrowing, thus encouraging greater spending, output, and employment.

In making these changes to the federal funds rate, the Fed used its classic method of changing the level of bank reserves. (See sidebar.) It is this method that the Fed jettisoned when it announced its new procedures.

After the failure of Lehman Brothers in September 2008, financial markets became unsettled and many of the traditional funding sources for financial institutions dried up. Into this void stepped the Federal Reserve, which dramatically increased its lending and other interventions to help the banks. In the process, it pumped money into the banking system and expanded bank reserves, significantly beyond the level of reserves necessary to maintain its target for the federal funds rate. .............(more)

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