Interest Rate Corridor.JPG
The idea of establishing either an interest rate floor, as depicted in Figure 6, or an interest rate corridor, as depicted in Figure 7, may become the Fed’s new operating procedure.
The corridor system starts with the floor (just explained) and adds a ceiling above which the funds rate cannot go. That ceiling is the Fed’s discount rate, d, because no bank will pay more than d to borrow federal funds in the marketplace if it can borrow at rate d from the Fed.
The Fed’s policymakers can then set the upper and lower bounds of the corridor (d and z) and let the funds rate float—whether freely or managed—between these two limits. Under such a system, the lower bound—the rate paid on reserves, z—could easily become the Fed’s active policy instrument, with the discount rate set mechanically, say, 100 basis points or so higher.
If the federal funds rate were free to float within the corridor, rather than remaining stuck at the floor or ceiling, the Fed could use it as a valuable information variable. If the funds rate traded up too rapidly, that might indicate the Fed was withdrawing reserves too quickly, creating more scarcity than it wants. If funds traded down too far, that might indicate that reserves were too abundant—that is, the Fed was withdrawing them too slowly. Such information should help the Fed time its exit.