Fed may abandon funds rate – Bernanke

The federal funds rate could become useless as a policy tool thanks to plans to increase banks’ reserves, according to testimony from Federal Reserve Board chairman Ben Bernanke.

Bernanke did not appear before the House Committee on Financial Services as planned, due to heavy snow in the Washington, DC area, but his pre-released written testimony stated “the level of activity and liquidity in the federal funds market has declined considerably, raising the possibility that the federal funds rate could for a time become a less reliable indicator than usual of conditions in short-term money markets”.

Instead, he suggested, the Fed could use a combination of the recommended level of bank reserves and the interest rate paid on excess reserves to indicate its policy target, which would be “an alternative short-term interest rate”.

This new approach could see the Federal Reserve bracket its target rate between the interest rate paid on excess reserves and the Fed discount rate, Bernanke proposed. This ‘corridor’ approach would tend to keep the funds rate within a set range: it would not rise above the discount rate because banks could simply borrow more cheaply from the Fed discount window; and it would not fall below the excess reserves rate because banks could then make a better return by depositing their cash as excess reserves.