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LONDON – As the Federal Reserve considers interest rate cuts to stimulate the U.S. economy, there is a lesser-known consequence to keep in mind: the income drag.

A unique aspect of the Fed’s easing cycle is its potential impact on cash income within the banking system. This dynamic could counteract the intended economic benefits of lower rates and pose challenges for the Central bank if things don’t go as planned.

Morgan Stanley analysts have highlighted the income boost from previous Fed rate hikes and the potential drag that could arise now. Unlike before, the Fed now pays significant interest to commercial banks for reserves held, particularly after balance sheet expansions post the 2008 financial crisis and the 2020 pandemic. The current level of excess reserves stands at around $3.1 trillion.

Additionally, the Fed utilizes interest on its daily reverse repo facility to manage liquidity, with volumes hovering around $300 billion to $400 billion. Traditional interest-bearing short-term assets like U.S. Treasury bills and money market fund assets are also set to be affected by rate cuts.

The impact of the Fed’s significant rate hikes in the past could be countered by the income drag resulting from rate cuts, potentially offsetting the intended stimulus effects. This may force the Fed to reduce rates further to counter the income drag’s effects, raising questions about the effectiveness of rate cuts.

If the Fed continues to push rates lower, the income drag could have wide-ranging effects on bank earnings, lending, corporate cash holdings, and wealth accumulation. While this may help moderate excessive stimulus, it could complicate the Fed’s ability to respond to economic shocks or deflationary pressures.

The prospect of near-zero rates may not be as far-fetched as previously thought, especially if the Fed struggles to gain traction with rate cuts. Speculation about low Inflation is already emerging globally, further complicating the Fed’s quantitative tightening plans.

Ultimately, the income drag from rate cuts may prompt the Fed to reconsider its balance sheet reduction plans. As the Central bank navigates its policy path, the potential impact of income dynamics on monetary policy effectiveness remains a key consideration.

(This article was written by a columnist for Reuters and has been modified for clarity and SEO purposes)

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