Excerpted with permission from the publisher, John Wiley & Sons, from The Little Book of Economics by Greg Ip. Copyright © 2010 by Greg Ip.
Luckily, in 2008 the Fed got a new tool to work with: the right to pay interest on excess reserves (IOER). If IOER is 2 percent, banks will keep those reserves at the Fed rather than lend them at less than 2 percent in the Fed Funds market. Tempting Speculators. Do zero interest rates entice hedge funds, banks, and others to plough borrowed money into risky investments? A lot of people think that's what happened when the Fed kept low rates from 2002 to 2004, bringing on the subprime crisis. And does it do the same in China and other countries who link their currency to the dollar and thus U.S. interest rates? There may be truth to this, but raising interest rates to combat speculation is a bit like using dynamite to eradicate termites: the remedy may do more damage than the problem. A more surgical response is to use regulations to limit risk-taking. Exit Strategy. When the economy has recovered, the Fed may want to sell those extra bonds. The reserves it created when it first bought the bonds would then disappear. Such selling should push up long-term rates, but by how much is hard to predict.