Under authority granted to the Federal Reserve under the provisions set forth by the $850 billion rescue package, the central bank may now begin paying interest on deposits held in the Fed’s vaults. In fact, the FOMC began working on its new policy tool almost immediately after the bill was signed into law. Currently the Board of Governors conducts monetary policy by targeting the rate at which banks may borrow from each other to satisfy the 10% reserve requirement set forth by the Fed. As of lately, the lock-up in credit markets has made it very difficult to hit the overnight target of 2.00%. Hence the goal of the new system is to ease these tight conditions by providing cash to these institutions. Fed Funds Daily Effective Rate 10/09/03 - 10/06-08 Source: Bloomberg The new ‘Channel’ target is a spread of about 75bp lower than the effective Federal Funds over one to two week period. That is, if the central bank manages to hit its overnight target of 2.00% for two weeks, then it will pay 1.25% on these deposits held at the Fed. For any reserves held in excess of the requirement, the central bank will pay the lowest target over a yet-to-be defined period minus 75bp. The negative carry trade implies that when commercial banks borrow overnight funds at the 2.00% rate to meet reserve requirements, that the central bank will rebate them an overnight rate of 1.25%. Thus, the net earning rate on these deposits becomes roughly 0.75%. The new measure has the goal of easing these liquidity concerns so as to also reduce the volatility of the benchmark rate. As such, forex traders should benefit if all goes according to plan. If the overnight rate becomes simpler to predict, traders will be allowed to forecast their rollover rates with a bit more ease. Fed interest payments will begin October 9.