Fed to bump up interest rate on reserves

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AP

WASHINGTON — The Federal Reserve announced Wednesday it will boost the interest rate paid to commercial banks on excess reserves, helping the central bank battle the credit crisis.

The move will encourage banks to keep excess reserves at the Fed because they will be earning higher interest on that money. That will give the Fed more control over interest rates and more leverage to battle the credit debacle.

Under the new formula, which takes effect on Thursday, the Fed will pay banks 1.15 percent on excess reserves. The Fed pays banks three-quarters of a percentage point under the old formula.

Congress in the recently enacted US$700 billion financial bailout bill gave the Fed the power to pay interest on reserves for the first time.

The Fed concluded that narrowing the difference between its key lending rate — called the federal funds rate — and the rate paid on excess reserves “would help foster trading in the funds market at rates closer to the target rate.”

The funds rate is the rate banks charge each other on overnight loans. That rate — now at 1.50 percent — is the Fed’s main lever for influencing overall economic activity. The change announced Wednesday should help keep the funds rate more stable.

“The board will continue to evaluate the appropriate setting of the rate on excess balances in light of evolving market conditions and make further adjustments as needed,” the Fed said.

Earlier this month, the Fed and other major central banks acted together to lower interest rates, the first coordinated action of that scope in the Fed’s history. The move is aimed at preventing the global financial meltdown from plunging the United States — as well as the world economy — into a deep and painful recession.

Many economists believe the Fed might lower rates again when policymakers meet at their next regularly scheduled session on Oct. 28-29. Further reductions to the Fed’s key rate would cause a corresponding drop to the prime lending rate charged on many consumer and small-business loans. Policymakers hope lower rates will spur people and businesses to buy more, thus reviving the moribund economy.