Federal Reserve May Seek Authority to Pay Interest on Reserves

By happenstance, there is more than usual Fed-related news this early AM. A few weeks ago, Greg Ip of the Wall Street journal recited what some of the Fed’s options would be if it ran into balance sheet constraints. One was paying interest on bank reserves:

The Fed could seek to pay interest on reserves. Banks lend out excess reserves at whatever rate they can get because the Fed doesn’t pay interest. That’s one reason the federal funds rate often crashes late in the day, when banks realize they have more reserves than they need. Paying interest on reserves would put a floor under the federal funds rate. The Fed could then make loans and purchase assets with little concern for the impact on the federal funds rate.

The Financial Times reports that this idea may be getting traction:

Federal Reserve policymakers will discuss paying interest on bank reserves in a closed door meeting on Wednesday. Such a move could in theory allow the Fed to expand its liquidity support operations without limit….

Under a law passed in 2006, the US central bank will gain the authority to pay interest on reserves in 2011.

The meeting on Wednesday is based on that timeframe and will not be followed by any announcements.

However, the meeting could spark an internal debate as to whether the Fed should consider asking Congress to bring forward this authority to help it deal with the current credit crisis.

Many experts think that would be a good idea. Vincent Reinhart, former chief monetary economist at the Fed, said paying interest on reserves would allow the Fed to “expand their liabilities to support more asset purchases”.

A number of other central banks already have the authority to pay interest on reserves, as well as the authority to lend banks money.

In normal times they can use these deposit and lending rates to put a corridor around the main policy rate, and prevent it from being buffeted too far away from the level they aim to set.

But at times of financial market stress, the ability to pay interest on reserves takes on added significance. Currently, the Fed cannot expand or contract its balance sheet without altering the overall supply of reserves and changing its main policy rate, the Fed funds rate…

That would free the US central bank to conduct liquidity operations that were larger than the size of its current balance sheet – roughly $800bn.

“The point…would be to allow the Fed to expand its balance sheet without having to drive the fed funds rate to zero in the process,” said Goldman Sachs.

The problem with this concept, as with many of the Fed’s new measures, is that notwithstanding the current improved mood in the credit markets, they have often been ineffective or produced unintended consequences. Per EconWeekly, paying reserves would have a nasty side effect:

Reserve balances are like checking accounts: they don’t earn interest. For that reason banks have little incentive to hold more reserves than they need to meet the Fed’s requirements and clear transactions. Any excess reserves are loaned to other banks. As Greg Ip explains, “if the Fed paid, say, 2% interest on reserves, banks would have no incentive to lend out excess reserves once the federal funds rate fell to that level.”

This measure would lead to a higher equilibrium level of reserve balances, for a given value of the federal funds interest rate. It would also reduce the amount of inter-bank lending, as banks would keep more of their cash in their safe-deposit box at the Fed. That lending would be replaced by loans from the Federal Reserve.

Um, I thought the problem we were trying to solve in the first place was banks not lending to each other…..

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9 comments

  1. S

    Yeah they should get rid of the auctions and call and end to the crisis. You have to love the justification, other CB fdo it. Is this the same circular logic Browbn used when he annonced the mortgage swap. The bad feedback loop continues. Bernanke is a failure and so obviously gutless.

  2. S

    What was the congressional mandate behind passing this legislation? Bill # etc.

    What are the implications if banks are induced to park more reserves at Fed?

    How can the Fed expand its balance sheet limitlessly (GS) and not impact money supply?

    Implications for banking system, weak banks in particular?

  3. Marcus Aurelius

    Hmmm… the quasi-merger of government and corporate interests – I think there’s a word for that…

  4. Richard Kline

    To Marcus Aurelius, that’s the ‘f-word,’ yes. . . . Other countries have gotten that in circumstances similar to ours, a context that worries me, though that hasn’t been _our_ historical context to this point.

    One circumstance of which there is a whiff in this discussion of Things to Do to Avoid Sucking Zirp, maybe, is that the truly negative consequences of further reductions in the FedFunds have finally hit home fully in Fedland. They may be moving, rather quickly for central bankers, to looking at ‘new and different options’ because they’re preferred options will get them a currency crisis they hopefully now intend to avoid.

  5. Anonymous

    Whom is this meant to fool? Or is it really meant for after interest rates hit zero?

    Moe Gamble

  6. Flow5

    Politicians and economists are telling me that they will take my tax dollars, and give them to the banks, so that the banks can make more money.

    This is both insane and criminal. When member commercial banks make loans to, or buy securities from, the non-bank public, they create new money & credit.

    The reverse operation is only true for a single bank – i.e., limited to the bank’s excess-legal reserve position.

    In reality, the system is composed of thousands of banks, and the new deposits thus created, via a series of interbank transactions, increase the balance of payments among virtually all of the banks within the Federal Reserve System.

    And how is this financial legerdemain accomplished? — through the Fed’s “open market power”, i.e., the New York Federal Reserve’s “trading desk” buys securities from the non-bank public (or increases the excess legal reserves of the banking system). The system as a whole is then able to create deposits by a multiple of its total excess reserves.

    E.g., on the basis of $1 of excess legal reserves added to the system by the FED, or the increase in $1 of “total reserves”; the “banking system” acquires $200 of additional earning assets (owing to fractional reserve banking – or its expansion coefficient).

    Thus, the bankers are able to create a vast superstructure of credit on a very small volume of legal reserves.

    So, if as the bankers & their collaborators say (this is a tax), then why is it that when excess reserves are added, do the member commercial banks collectively make more money…more than they would even if the volume of legal reserves was smaller? (and more than the banks would even if they were already receiving interest on their clearing balances, et. al.)

    The banks will still have to hold prudential or liquidity reserves anyway (their primary or “working” reserves).

    This Financial Services Regulatory Relief Act of 2006 is bullshit. The tax is the one on the citizens of the United States, and also the one on these collaborator’s minds. If you want to subsidize someone, lower my taxes.

  7. Flow5

    Every country which utilizes the provisions within “The Financial Services Regulatory Relief Act” publishes M3.

    I.E., ALL OF THESE COUNTRIES OPERATE WITH ZERO RESERVE REQUIREMENTS & A “POLICY RULE”.

    And New Zealand pioneered this monetary policy rule and zero reserve requirements & was cited as an example by Govenor Kohn of how well it was working: Guess What? “New Zealand Dollar Hits 25 Yr Highs After Insterest Rates are Raised to 8 Percent”

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