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Wednesday, May 07, 2008

"Another Tool for the Fed?"

Barry Ritholtz notes:

Another Tool for the Fed?, by Barry Ritholtz: Have you ever even thought about this?

"The Federal Reserve is formally asking Congress for authority -- starting this year -- to pay interest on commercial-bank reserves, in an effort to gain better control over interest rates and more leverage to battle the credit crunch...

In 2006, Congress gave the Fed permission to pay interest on reserves -- the sums banks keep on deposit at the Fed -- but it delayed the effective date of the legislation until 2011 to postpone the cost to the Treasury.

Banks are required by law to hold a certain fraction of their deposits in reserve accounts at the Fed, but receive no interest on these deposits. Having the authority to pay interest would solve two technical headaches for the Fed.

If they earned interest from the Fed, banks would have no incentive to lend out excess reserves for less. That would make the Fed's benchmark federal-funds rate, which banks charge on overnight loans to each other, less likely to plunge below the Fed's official target -- now 2% -- on days when the banking system was awash in cash.

I'll bet this sort of stuff never even entered your thinking . . .

I don't think he is talking to me, but if he's willing, I'll take that bet. It's interesting how much attitudes toward regulation have changed in the two years since that post, "Regulatory Relief for Banking Organizations," was written.

Also, given our recent financial market troubles, the second "technical headache" that is solved is worth noting:

In addition, the Fed could theoretically combat the credit crunch by buying securities or extending loans without limit without causing the federal-funds rate to fall to zero, something that could fuel inflation or distort markets. ...

To combat the credit crunch, the Fed has replaced half the roughly $800 billion of Treasurys it held last July with loans to banks and securities dealers.

If the Fed used up all those Treasurys, it could purchase more, but in the process it would create large quantities of excess reserves. As banks lent out those excess reserves, the federal-funds rate would fall to zero. By paying interest on reserves, the Fed could put a floor under the funds rate and expand its balance sheet to deal with the credit crunch. The Fed, however, has not cited that as the immediate objective of its request.

    Posted by on Wednesday, May 7, 2008 at 12:33 AM in Economics, Monetary Policy, Regulation | Permalink  TrackBack (1)  Comments (10)


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    Last week, the Fed decided to ask Congress for the right to pay interest on bank reserves. (Hat tip B... [Read More]

    Tracked on Sunday, May 11, 2008 at 04:34 PM


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