Fed asks for new powers

May 8, 2008

For Central Banking junkies out there, Grep Ip is the journalist you need to read. He covers all things Fed for the WSJ. Yesterday he published a fascinating article about the Fed’s request to start paying interest on reserves held in its vaults. This would give the Fed yet more power to control the money supply, and would help avoid the consequence of pushing the Federal Funds rate toward 0% if they’re forced to act more aggressively to pump liquidity into the markets (see Economic Busts: Japan, circa the last 18 years).  It would probably also discourage banks from hiding assets in off balance sheet vehicles.  The more assets banks have ON the balance sheet, the more 0% interest reserves they must park at the Fed.

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.

The people familiar with the matter said key Democratic and Republican lawmakers probably would greet the request favorably, but warned quick passage of the measure isn’t guaranteed, given the political sensitivity of any steps that might aid banks.

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.

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.

Paying interest on reserves would reduce the sum the Fed remits to the Treasury each year from earnings on the central bank’s portfolio of Treasury securities and loans. When the 2006 legislation passed, the Congressional Budget Office estimated the move would cost the government $1.4 billion over five years.

The Fed’s staff have suggested two ways Congress could proceed. It could let the Fed pay interest on all reserves, at a cost of about $150 million a year, people briefed on the estimates said. Alternatively, the Fed could pay interest only on reserves in excess of banks’ required minimum. That would cost only about $30 million a year, which might make it more attractive to lawmakers.

Either way, the Fed would have to keep the interest rate paid on reserves close to prevailing short-term market rates. In practice, the rate would probably be slightly below the federal-funds rate. The Fed would like Congress to act before its August break, to permit implementation by year-end, people familiar with the conversations said.

The Fed manages interest rates by purchasing securities or making loans to banks and securities dealers. When the Fed buys Treasurys or makes loans directly to banks, it supplies financial institutions with cash; in effect, it prints money. The cash ends up as currency in circulation or in banks’ reserve accounts at the Fed. Since reserves earn no interest, banks lend out cash that exceeds their required minimum reserves, putting downward pressure on the federal-funds rate.

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.

Fascinating stuff, explored in more excruciatingly interesting detail by Marvin Goodfriend in a paper he published in the NY Fed’s Economic Policy Review back in 2002.

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A good post that explains simply what others can go on for pages about. So is credit inherently inflationary? We hear about the danger of “printing money” by governments. That would be inflationary by definition since nothing is being created of value to accompany the increase in circulated money.Lending, on the other hand, is money being created with the idea of something new coming along with it that it will buy, a house being built for example. It also brings an obligation to repay the loan, bringing future money into the present, you might say.So, again, is extending credit in itself inflationary to any degree?

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