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Sunday, September 28, 2008

Emergency Economic Stabilization Act of 2008

Here's the full text: Emergency Economic Stabilization Act of 2008.

Here's the CBO analysis of the proposal.

I'm with everyone else. The proposal could be better, but as I've argued all along, the problems are real and if this is the best we can get - and it appears that's the case - then it will have to do.

Others: Paul Krugman [2, 3], Brad DeLong, Economists' for Obama, Interfluidity, Justin Fox, Adam Levitin, Larry Summers, Barry Eichengreen, Stan Collender, Paul Krugman, Nouriel Roubini, Dean Baker, Greg Ip. Extra: Understanding the TED Spread.

Update: One section would:

Allow the Federal Reserve System to pay interest on certain reserves of depository institutions that are held on deposit at the Federal Reserve, starting on October 1, 2008

That gives banks with reserves on deposit with the Fed an infusion of capital, but not sure how large and it's unlikely that's the reason for the change (which is to stabilize the federal funds rate within relatively narrow bounds - see below - and because it no longer has to sterilize injections of reserves into the banking system through open market operations, again, see below). I've written about this before (as far as I know, removing reserve requirements isn't part of the bailout proposal, just paying reserves on deposits - the following is from March 2006 and discusses changes scheduled for 2011):

This (discussed previously here) brings up the possibility of a "channel" or "corridor" system for setting the federal funds rate as is currently in place in Canada, Australia, and New Zealand. A channel/corridor system makes open market operations unnecessary and allows the Fed, as proposed elsewhere on the proposed list of regulatory changes, to remove reserve requirements.

Currently, the federal funds rate is capped by the discount rate. Since the Fed will lend to banks at the discount rate, no bank would pay a higher rate in the federal funds market so the federal funds rate cannot go any higher than the discount rate. Similarly, with the ability to pay interest on deposits, no bank would lend to another bank at less than the rate the Fed will pay on deposits, so the federal funds rate cannot be lower than this. These two bounds are shown in the figure below (copied from Mishkin's text). Notice that if these bounds are fairly tight, the federal funds rate will be controlled precisely (for more on this point, see Woodford).  In addition, keeping the federal funds rate on target does not require open market operations, only discount window (lombard facility) borrowing and lending.

Larger version

The Woodford article explains some of the advantages of this system (though it's a bit technical).

Update: John Jansen notes this from JPMorgan explaining why being able to circumvent open market operations is important:

This change would greatly increase the ability of the Fed to expand the size of its existing liquidity facilities. Under current procedures, any time the Fed has provided market liquidity by injecting reserves into the banking system — be it through the TAF, PDCF, discount window lending, lending to AIG, or other forms of Fed lending — the increase in reserves has had to be ’sterilized’ by selling Treasuries, conducting reverse repos, or, more recently, through the novel route of having the Treasury overfund itself to increase its account at the Fed. Those means of sterilization threatened to run up against certain balance sheet constraints: the Fed now has less than $250 billion of Treasuries that it hasn’t lent out through the TSLF and TOP, and the Treasury’s overfunding could eventually bump up against the debt ceiling.

With interest on reserves, the Fed would not have to sterilize injections of reserves into the banking system. Normally, reserve injections need to be sterilized to prevent the fed funds rate from undershooting the FOMC’s funds rate target. With interest on reserves, wherever the Fed sets the rate on its deposit facility would effectively set a floor under the funds rate...

One proposed operating procedure using interest on reserves, called the floor system or the Goodfriend system, would have the Fed set the deposit rate at the FOMC funds target rate and then inject massive amounts of reserves into the banking system — possibly by increasing TAF or similar facilities — and allowing the excess reserves to be deposited with the Fed at the target rate. Following such an operation, the Fed’s balance sheet would contain more risky assets and — on the liability side — more deposits (the monetary base would be roughly unchanged); the private sector’s balance sheet would contain less risky assets and more safe assets in the form of deposits with the Fed. The effect on the private sector balance sheet from the TARP is similar, though in that plan Treasury debt takes the place of Fed deposits.

The Fed has not discussed how soon they might implement interest on reserves, one obvious reason being that the proposed legislation hasn’t yet become law. Because this power would be granted roughly contemporaneously with the TARP, the Fed may choose to see how effective the TARP is before setting up a deposit facility as a tool to help address the credit crisis.

    Posted by on Sunday, September 28, 2008 at 07:47 PM in Economics, Financial System | Permalink  TrackBack (1)  Comments (11)


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