From Credit Writedowns:
The Fed could announce a federal funds target of 3% but the tsunami of excess reserves now out there swamps any conceivable demand, so the Fed funds rate would be guaranteed to remain stuck at zero. The target would be meaningless.-Ryan Avent as quoted in Why the Federal Reserve wants to drain excess reserves, Dec 2009
This is the problem for the US Federal Reserve. And now that people are talking seriously about exit strategies for the Fed, it makes sense to discuss these mechanics. Yes, I know some people are still talking about QE3, but let's deal with that if and when the economy swoons after QE2 is over.
What got me to thinking about this was a Bloomberg article about James "Seven Faces of The Peril" Bullard. Remember, Bullard is the Fed official which got us started on the road to QE2 when he said:
Under current policy in the U.S., the reaction to a negative shock is perceived to be a promise to stay low for longer, which may be counterproductive because it may encourage a permanent, low nominal interest rate outcome. A better policy response to a negative shock is to expand the quantitative easing program through the purchase of Treasury securities.When Bullard said those words, everyone knew the Fed was going to start buying up Treasuries....MORE