Fed To Pay Interest?

Fed Paying Interest On Reserves: An Old Idea With A New Urgency, Or
How The Banks 'Bypassed' The Fed Reserve System (To Their Great Current Regret!)

By Greg Ip, WSJ | 30 April 2008

Milton Friedman back in 1959 argued commercial banks should earn interest on the reserves they are statutorily required to hold on deposit at the central bank. That refrain was later picked up by the Federal Reserve. The rationale: by using open market purchases and sales of securities, the Fed adjusts the quantity of reserves banks hold and thus the interest rate they charge on excess reserves banks lend to each other (the federal funds rate). But since required reserves earn no interest, they are a tax, and like all taxes, create distortions. Over time banks minimized the portion of their deposit base subject to requirements and met a growing proportion of the remaining requirement through currency in their vaults rather than cash on deposit with the Fed. The Fed worried that eventually, required reserves would be so low it would have trouble implementing monetary policy. If banks earned interest on reserves, these problems would be mitigated.

Another benefit: at present, if the Fed oversupplies reserves through open market operations in the morning, banks may end up lending out at any rate they can get in the afternoon, causing the funds rate to plunge well below target. If they earned interest on those reserves, they wouldn’t lend them out at below that rate, preventing such late-day crashes.

Marvin Goodfriend, a former research director at the Richmond Fed and now a professor at Carnegie Mellon University, argued back in 2002 that paying interest on reserves would free up open market operations to pursue other goals, such as changing the mix of securities and loans the Fed held to affect the liquidity in various parts of the financial market. For such "broad liquidity management … a central bank might need the latitude to enlarge its balance sheet considerably and to vary the size of its balance sheet within a wide range independently of interest rate policy," he said in a study presented at a New York Fed conference. "That is not possible" unless the Fed paid interest on reserves.
Mr. Goodfriend’s paper presciently foreshadowed the Fed’s current situation. Since August it has sold off or lent out half the $800 billion in Treasurys on its balance sheet in return for less liquid loans and securities to restore normalcy to credit markets. It faces the prospect, though small, of using up the remainder if the credit crisis worsens.

It could expand its balance sheet without limit if it was willing to let the federal funds rate fall to zero (what the Bank of Japan called "quantitative easing" when it tried that strategy). But that could fuel inflation or create other distortions in the financial market. Getting the right to pay interest on reserves would remove that constraint.

The Fed got the authority to start paying interest in October 2011 under the Financial Services Regulatory Relief Act of 2006, signed into law on Oct. 13, 2006. The reason for the late implementation was budgetary. Paying interest on reserves will reduce the amount of income the Fed earns on its securities portfolio and remits to Treasury each year. Congress pushed back the date of implementation to minimize the near-term impact on the deficit.

The cost isn’t astronomical. The Congressional Budget Office estimated that the cost in the first year would be $253 million, rising to $308 million by the fifth year, for a total $1.4 billion over five years. It based that estimate on the assumption that the federal funds rate would average 4.5% from 2008 to 2016 and the Fed would pay interest at a rate 0.1 to 0.15 percentage points below that. It projected required reserves of about $8.3 billion.

The law also gives the Fed the flexibility to eliminate required reserves altogether. Banks would still have to maintain some reserves at the Fed to clear payments with each other. CBO assumed the Fed would not phase out those requirements.

The Fed has already raised the issue with Congress, although it hasn’t made a formal push. Getting Congress to agree to swallow the cost a few years early in principle shouldn’t be hard since Congress has already set aside its adherence to the principal of "Paygo"— that all revenue reductions and cost increases need to be offset elsewhere. The Fed could also further reduce the cost by arranging to pay interest only on excess reserves— the amount that exceeds the required minimum.

A risk for the Fed is that if Congress agreed to give it the authority to pay interest on reserves immediately, it might ask the Fed to so something in return— say, help out the student loan or auction-rate securities market. The Fed’s request could become bogged down in legislative wrangling. The Fed may thus elect to wait until events make the need more pressing. At that time, Congress may be willing to quickly pass a clean bill. President Bush would almost certainly sign it.

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Normxxx    
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