Fed’s Plan on Exit Strategy

In Financials, Politics on November 18, 2009 at 16:44

With the debate on the existence of asset bubbles escalating, analysts are forecasting Fed’s next move on the conduct of monetary policy. This week, Fed’s Vice Chairman, Donald Kohn, said there were no signs of an asset bubble and pledged to continuing expansionary monetary policy. When the time comes and the Fed decides its time to curb inflationary expectations, there is a consensus it will rely on raising the interest paid on banks’ reserves.

Congress granted the right to the Fed to pay interest on banks’ reserves on October 2008 in an effort to address the issue of undercapitalisation in the broader crisis-context. With the Fed paying higher interest on banks’ reserves, it creates a floor on their portfolio returns and forces banks to keep their money with the Fed in case market returns are lower. The objective here is to reduce banks’ aggressiveness and contain their risk-appetite. It also works as an indirect way to withdraw funds from the markets and reduce the likelihood of asset bubble build-ups.

Tagged along to this untested monetary policy, the Federal Reserve is also expected to engage in ‘open market operations’ and sell T- bills for a short-term period to private banks. Federal Reserve Bank of St. Louis President, James Bullard, anticipated that the Fed will not increase key rates until 2012, arguing Fed’s policy record on similar occasions of the recent past.

I happen to find this new policy of higher interest on banks’ reserves a very interesting approach on this issue as it works as the middle solution between the opposing challenges of inflationary expectations and growth. It manages to set a lower boundary on market liquidity without directly forcing money withdrawal and threatening the economy with contractionary spiral effects. Depending on market returns and macro levels, the Fed can accordingly adjust the interest and better influence liquidity.

by the Self-Seeker

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