3) As conditions in short term financial markets improved during the summer of 2009 the Fed closed down its lending under these programs. However, throughout the next 4 years the Fed increased substantially its purchases of longer term mortgage backed securities and Treasury notes from banks in a series of 3 “Quantitative Easing” (QE) Programs. This infusion of reserves led to a situation where in the aggregate commercial banks in the US accumulated substantial excess reserves. Even today although the volume of bank lending has grown, there is still a very large volume of excess reserves held by US banks. The Fed is now on a path to gradually raise the Federal funds rate and other money market rates back to more normal levels. It increased its Fed funds target range by 1/4% (25 basis points) in December 2015, another 1/4% in December 2016 and yet another 1/4% hike in its FOMC meeting last week. It has signaled that it expects economic conditions to warrant two more 25 basis point increases in the rest of 2017.
A) With all these excess reserves held by banks, simply slowing down or even halting Federal Reserve purchases might have very little effect in the short run in raising the actual fed funds rate consistent with increases in the Fed’s target. Draw a supply demand diagram of the Fed funds market to illustrate the current situation with banks holding substantial excess reserves.
B) What relatively untested policy tools will help the Fed deal with this problem? Explain. ( Hint: In addition to my class notes on the federal funds market you may wish to look at www.federalreserve.gov then click monetary policy…then Policy Normalization: Principles and Plans)