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Why is the Fed Paying Interest on Excess Reserves?
Today the Fed starts to pay interest on reserves. The zero interest on required reserves was an opportunity cost to banks, a tax if you like, so paying interest lifts the tax. Reducing taxes on banks at the present time makes sense and in the long run there are some efficiency gains from paying interest on required reserves, especially to the extent that the previous system could be gamed. Overall, however, this is small potatoes.
More interesting is why the Fed. will pay interest on excess reserves. In the long run, there are again efficiency gains but why would the Fed. want to make it more profitable for banks to hold excess reserves now when we want every dollar in the credit markets? My best guess is that the Fed. wants to play more Operation Twist and in Brad DeLong's terms this gives them an additional tool to do it on the Pan-Galactic scale. In short, they will buy long bonds and commercial paper or other such asset and use the interest payments on excess reserves to sterilize. Although paying interest on excess reserves brings this whole operation under the Fed house it's unclear to me, however, how the situation is markedly different than with Fed/Treasury cooperation.
Posted by Alex Tabarrok on October 6, 2008 at 10:19 AM in Economics | Permalink
Comments
interesting, i hadn't thought about
this angle before.
i'll add that sterilization in a market
expecting deflation is no good thing.
Posted by: sa at Oct 6, 2008 10:44:31 AM
Perhaps the point here is to get banks to keep more of their money liquid and in their reserves, rather than tied up in illiquid assets.
So maybe the idea behind this is to build up a stronger liquid base, which would in turn reduce uncertainty surrounding inter-bank lending.
Posted by: pants at Oct 6, 2008 11:02:46 AM
Fed deposit remuneration and Fed treasury cooperation are essentially the same: treasury bonds are the equivalent of Fed deposit.
The difference lie in liquidity: while Fed deposits are perfectly liquid treasury bond are not (it depends on the term of the bond).
The advantage of this approach is that Fed is more autonomous from treasury.
By the way, European Central Bank renumerates deposits at the "repo rate" since the beginning of the Euro (at 1% below the directing rate).
Posted by: jean at Oct 6, 2008 11:31:15 AM
Don't you want banks that have excess liquidity to loan these reserves out to other banks, instead of the Federal Reserve? Also, is the pumping of money into the money market by the Feds not counterproductive, when banks use this money to buy up bonds in the capital market? And when governments need to borrow money on the money or capital markets for their bailouts, won't they compete with those weaker financial institutions who are trying to do the same?
Posted by: kurt at Oct 6, 2008 12:46:37 PM
I'm confused about what you mean by interest payments sterilizing the long bonds they buy. I can see why these payments will be setting a floor on the fed funds rate, maybe that's what you mean. However, in what sense does it sterilize? The payments aren't soaking up the money in any way?
And isn't the difference with Fed/Treasury cooperation that this will let them hit the target?
Posted by: a student at Oct 6, 2008 3:47:39 PM
The reserve requirements are supposed to make banking safer, but I fear they have the opposite effect. Coupled with fair value accounting, its driving banks into a position where they cannot make loans.
Both of these requirements let past gambles keep good investments from happening. But maybe these banks need to be disciplined.
We have a schizophrenic situation. We protected these banks from the discipline of the marketplace and wish to substitute our own discipline as it is somehow wiser.
Me thinks that people who actually own the money involved might be a little more incentivized to act to save it then the dump-it-forward politicians in Washington.
Politicians only seem to be incentivized to act on behalf of campaign contributors, who need just a little more time to get out of Dodge.
Posted by: Alan Brown at Oct 6, 2008 8:26:06 PM
