Banks May Now Earn Interest on Required Reserves Thanks to U.S. Rescue Plan

The Federal Reserve may be equipped with a new tool in conducting its monetary policy if the final version of the U.S. rescue bill receives congressional and executive approval. Under the new provision, reserves held at the central bank would earn interest as decided upon by the Fed.

Commercial banks are currently required to hold 10% of client deposits in the vaults of the central bank while earning no monetary compensation in return. With the new authority that Chairman Ben Bernanke and the Federal Open Market Committee may gain, these banks will be granted greater liquidity in the form of the interest payment that they earn on these reserves. As early as October 1, these new policies may come into effect.

Currently the Board of Governors conducts monetary policy by targeting the rate at which banks may borrow from each other to meet these reserve requirements. As of lately, the Fed has had trouble stabilizing the 2.0% Federal Funds Rate. Since September 15 the cost of borrowing money overnight hit a low of 0.0625% and a high of 6.0%.

The new measure has the goal of easing these liquidity concerns so as to also reduce the volatility of the benchmark rate. As such, forex traders should benefit if all goes according to plan. If the overnight rate becomes easier to predict, traders will be allowed to forecast their rollover rates with a bit more ease.

The image above shows the price action of the Federal Funds Rate over the past five years. As one may notice the sharp gyrations of the rate have been significantly stronger since the beginning of the subprime meltdown in July 2007.

DailyFX

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