A Forex View From Afar

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More Funds For Banks From The Fed

Written by A Forex View From Afar on Friday, November 07, 2008

Recently, the Fed made a revolutionary decision (which, by the way is used by the most central banks) to pay interest rates on the bank’s funds that are held at the central bank.

U.S. based banks are required to hold a portion of their deposits and notes at the central bank. Depending on the bank’s activity, the reserve requirements can vary from one day to the next. Therefore, some banks will have a surplus, while others will need additional funds to meet the minimal reserve requirements.

Now here comes the Fed: until the credit crunch reached its peak, the Fed did not pay an interest rate for these funds, so banks saw no need to hold any excessive funds. However, the developments in the financial markets pushed Congress to vote the measure into law, so the Fed could actually encourage banks to lend to each other in the Fed Funds market.

Until now, the Fed paid for the minimal reserve funds, the Fed targeted rate minus 10 basis points, while for the excessive funds it paid the Fed’s targeted rate minus 35 basis points. However, the Fed has made the decision to alter the rates the banks receive for their available funds. From November 6, the Fed will pay for both the reserve requirements and excessive funds the Fed targeted rate over the maintenance period.

In the short run, the Fed will boost the cash available for banks, dragging the Libor rates lower. In addition, the decision to increase the interest paid on banks’ cash will help the Fed Funds Rate, which is now at 0.22%, to come closer to the targeted 1%.

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