What Ben and I discussed over lunch...
Fed to Consider Paying Interest
To Commercial Banks on Reserves
By GREG IP
April 28, 2008 7:31 p.m.
Federal Reserve officials on Wednesday will discuss the implications of paying interest on commercial bank reserves, a step that would give the Fed considerably more capacity for combating the credit crunch.
In an announcement on its web site Monday, the Fed said "the implications of interest on reserves for monetary policy implementation" will be discussed at a meeting of the Federal Reserve Board Wednesday.
Banks are required by law to hold a certain fraction of their deposits in reserve accounts at the Fed. They earn no interest on those reserves. For technical reasons, that makes it difficult for the Fed to significantly expand lending to financial institutions without letting short-term interest rates fall to zero.
Under a 2006 law, the Fed got permission to pay interest on reserves starting in October, 2011. To do so sooner would require an act of Congress. Fed officials have discussed that possibility with both House and Senate aides, people familiar with those conversations say. House Financial Services Chairman Barney Frank is supportive, these people say. The views of his Senate counterpart, Chris Dodd (D-Ct.) are unclear.
There is no sign yet that the Fed is about to press Congress to act. It is being discussed now in part because Chairman Ben Bernanke in late 2006 asked Fed staff to study it. The results of that research will be presented to the five-member board on Wednesday as well as the entire 17-member policy-making Federal Open Market Committee.
"I don't think it's something for this or even next week but it does signal that the Fed is … trying to think about ways to provide liquidity without lowering rates," said J.P. Morgan Chase economist Michael Feroli.
The FOMC concludes a two-day meeting Wednesday at which it is expected to trim its target for the federal funds rate a quarter of a percentage point to 2%. The accompanying statement is expected to keep the door open to further rate cuts, given the risks still facing the economy, while dialing back the probability of such cuts.
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 cash that exceeds their required minimum, putting downward pressure on the federal funds rate.
Since August, however, it has separately tried to improve lending conditions by altering the mix of securities and loans on its balance sheet. Since the credit crunch began in August, the Fed has sold off or lent out some $400 billion of its $790 billion in Treasury securities to banks and securities dealers in return for less-liquid collateral. The Fed could in theory purchase securities and make loans without limit. But doing so would cause bank reserves to skyrocket and the federal funds rate to fall to zero. The Fed may want to avoid that because it may fuel inflation and distort financial markets. If the Fed paid interest on those reserves, that would be a floor for the federal funds rate, since a bank would not lend out reserves for less than it would earn from the Fed.
Write to Greg Ip at greg.ip@wsj.com |
