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Fed propping up CD rates?

By Claes Bell, CFA ·
Monday, August 15, 2011
Posted: 3 pm ET

It seems a lot of CD investors are annoyed with the Fed for keeping federal rates near zero for the better part of three years. They argue the Fed's loose monetary policy is keeping CD rates so low it's impossible to earn a decent return.

But one thing they might not realize is that in a back-door way, a relatively new Fed policy may be putting a floor under CD rates that they might not otherwise have been there.

In 2008, Congress authorized the Fed to begin paying interest on banks' excess reserves held at the central bank. The idea was to bolster the Fed's ability to put a floor under interest rates, keeping money markets alive and providing a lever to help control inflation in the event the Fed's low rates and massive liquidity injections into the market touched off inflation. Initially, the Fed offered a 1 percent return, but that was quickly reduced to .25 percent.

A quarter of a point of interest may not seem like a lot, and in a normal economy, it wouldn't have all that much value. But having a risk-free, interest-bearing place to keep excess reserves has a lot of value for banks in an economy where qualified borrowers are hard to find and loan demand, particularly for commercial loans, has been sluggish at best. The proof is in the pudding; since the Fed started paying interest to banks, financial institutions have stashed $1.6 trillion worth of excess reserves at the Fed.

For CD investors, I think the Fed's promise of interest on excess reserves has provided a floor to CD rates that might not otherwise have been there. As long as banks can be confident they'll be able to earn at least something on the money they take from CD investors, with a strong upside should the economy improve and more profitable places to invest that money materialize, they'll probably be willing to pay something for CD investor's deposits. Absent that, it seems evident CD rates would fall as banks' demand for deposits dropped to even more anemic levels.

There's been some speculation the Fed might push the interest rate on reserves down to zero to encourage banks to lend some of that $1.6 trillion out to U.S. consumers, businesses and other banks. If that happens, I'd be money market rates and short-term CD rates alike would take a hit.

That may not happen, though. The Obama Administration is said to be considering Harvard professor Jeremy Stein, who has done extensive research on the effects of the Fed paying interest on reserves, for one of the open spots on the Federal Reserve's Board of Governors. Stein's recent paper on the subject suggests he sees it as a valuable tool for achieving optimal market conditions.

What do you think? Is the Fed paying interest on reserves propping up CD rates? Should the Fed continue the policy, or should it force banks to lend money in the marketplace to achieve returns?

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1 Comment
betty vamos
August 17, 2011 at 6:09 am

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