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The Wall Street Journal – Fed Seeks Approval to Pay Interest to Banks
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. Senior central-bank staffers broached the subject earlier this week with the congressional committees that oversee the Fed, people familiar with the conversations said. Fed Chairman Ben Bernanke is expected to request the new authority in writing soon…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. 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.
Comment This idea has been talked about for quite some time now. Congress went as far as giving the Federal Reserve permission to pay interest on bank reserves, but not until 2011. Why does the Federal Reserve need Congressional approval? Because all profits earned by the Federal Reserve are returned to the Treasury and this would cut into profits.
As the highlighted part above says, the Federal Reserve wants to greatly expand its balance sheet. The problem is that doing so would “over-reserve” all the banks’ reserve accounts causing all of them to be sellers of fed funds as reserves pay no interest. If the Federal Reserve began to pay interest on reserves, the need to sell funds would diminish.
The article above says the Federal Reserve wants to do this to prevent “the funds rate from falling to zero, something that could fuel inflation or distort markets.” We only partially agree with this. It is true that paying reserves would prevent the funds rate from falling to zero. If the funds rate hit zero, it would cease being an effective monetary tool. And yes a zero funds rate would distort markets, especially short-term borrowing markets like repo. But note it would not prevent inflation. Rather, it would stoke inflation. If we use the monetary definition of inflation; “too much money chasing too few goods,” then paying interest on reserves gives the Federal Reserve even more incentive to inflate and cause inflation.
While moving this date up would give the FOMC more flexibility in conducting policy, it certainly does not instill confidence that the credit crunch is behind us. In the end, all the Federal Reserve may do is exchange the credit crisis for inflation.