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Federal Reserve weighs options on how to raise US rates

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Robin Harding 
Financial Times
May 26, 2014

How do you persuade people to pay for the air they breathe? That is the problem the US Federal Reserve is wrestling with, as it tries to figure out how it will eventually raise interest rates, after its quantitative easing programmes left banks saturated with reserves.

In the past, the Fed raised rates by reducing the supply of bank reserves. Banks have to hold a minimum level of reserves, so when the supply fell, they would pay more to borrow them – and then pass that rate on to their customers. The supply of reserves was like oxygen underwater: an essential commodity in limited supply. The market interest rate for borrowing bank reserves overnight is known as the Fed Funds rate. Such was the Fed’s experience at managing this market, that the Federal Open Market Committee could decree a rate, and then the New York Fed’s markets desk would fine tune the supply of reserves to hit it precisely.

Today, the situation is different: after three rounds of quantitative easing, banks have reserves at the Fed almost $3tn greater than the regulatory requirement. Reserves are everywhere, like air above water: no bank needs to borrow them. The Fed could suck out a bit of oxygen and it would not make any difference to the price.

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This article was posted: Monday, May 26, 2014 at 5:56 am

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