We know how the Federal Reserve used to raise interest rates. It raised the rate at which banks can borrow from each other — the federal funds rate — limited the supply of funds available for banks to borrow, and presto, rate hike.

But that’s no longer the case.

During the recession, the Federal Reserve tried to stimulate the economy by purchasing large quantities — more than $4 trillion worth — of securities including treasuries and mortgage backed securities in a move called ‘quantitative easing.’ When the Fed purchased these assets, it would transfer money into banks’ reserve accounts at the central bank. The result is that the reserve accounts of banks are vastly larger than they need for their own purposes or are required by law.

“These banks are completely awash in trillions of excess reserves,” said Krista Schwarz, assistant professor of finance at the Wharton school and veteran of the New York Federal Reserve Bank. “So if the federal funds rate were allowed to set itself according to supply and demand in market it would drop to zero right now because nobody needs to borrow anything.”

No reasonable amount of intervention in the open market can influence supply and demand of reserves, and therefore interest rates, for cash borrowing between banks and financial institutions.

So what to do now that the Fed’s tool is broken?

“Now it’s a different game it all works differently,” said Joe Gagnon, a senior fellow at the Peterson Institute for International Economics. “This time what they’re going to do is they’re going to just pay banks more interest on the reserves they own.”

Read the article “Here’s How the Fed Will Raise Interest Rates” on marketplace.org.