Don Miller, Associate Editor of Money Morning, reviews the process and implications of the Fed’s possible plan for raising intereste rates without actually raising the rate itself.

Don Miller (Money Morning):
The U.S. Federal Reserve may take an unorthodox approach to raising interest rates by paying interest on bank reserves rather than relying on traditional open market remedies, as it exits from its long-term fiscal stimulus programs, Reuters reported today (Tuesday).

Paying interest on reserves is mostly untested and would represent an unexpected twist in the Fed’s response to the financial meltdown.

“In the old days … the Fed controlled the federal funds rate with open market operations,” Antulio Bomfim, a former Fed economist now with Macroeconomic Advisors LLC in Washington told Reuters. “Now, at least in this period when reserves are over-abundant, the way the Fed hopes to raise the federal funds rate will be primarily by raising the interest rate it pays on reserves.”

Usually, when the central bank wants to set a target for the federal funds rate it buys or sells Treasury securities on the open market, influencing interest rates by deploying or withdrawing capital.

By paying interest on reserves, the Fed makes it attractive for banks to keep their money at the central bank as long as interest rates in private markets are lower.

By doing that, the Fed can put a floor under the lending rate that banks charge each other for overnight loans, which is the central bank’s traditional choice for influencing the economy. Open market operations to raise interest rates would be relegated to a supporting role in the initial stages of tightening.

In order to spark an economy mired in deep recession . . . Click here to read the rest of Mr. Miller’s article.