Another Tool for the Fed ?

Have you ever even thought about this?

"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…

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.

I’ll bet this sort of stuff never even entered your thinking . . .

>

Source:
Fed Seeks Approval to Pay Interest to Banks
GREG IP
WSJ, May 7, 2008
http://online.wsj.com/article/SB121011673771072231.html

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What's been said:

Discussions found on the web:
  1. Pat G. commented on May 6

    “I’ll bet this sort of stuff never even entered your thinking . . .”

    Much worse has entered mine.

  2. shrek commented on May 6

    I swear this country isbeing run by morons. At some point an adjustment to the US economy is going to come no matter what the fed does. All these stupid ideas are going to buy us what? Another year. Maybe another wild bubble. Does the fed understand the greater they try to prevent markets from clearing and the more safety nets they try to place the more aggressive and leveraged this system becomes. If this is the attitude we are going to blow up the entire global banking system. Im amazed that not only are regulators not concerned about putting in better rules they are actually trying to compound policy mistakes. What a bunch of morons. Paul Volcker seems like the only fed chairman who lives of the planet known as earth. We’ve traded simple commen sense for a ton of bad math and theory.

  3. Stuart commented on May 6

    ok, so where does the Fed get the money to pay the interest? Inflate?

  4. Marcus Aurelius commented on May 6

    I’ll bet this sort of stuff never even entered your thinking . . .

    ….but I have a sneaking suspicion that it will find a way to enter my wallet.

  5. Johnnyvee commented on May 6

    I can’t help but cringe every time I hear Kudlow say the words “free market”. Whatever free market there was in my life time has been smashed.

  6. JS commented on May 6

    Is it even worth mentioning that those deposits are yours and mine and that paying interest on them to banks is indirectly stealing from our taxes?

  7. Winston Munn commented on May 6

    I suppose the Fed will be paying reserve interest out of those enormous profits from trading treasuries for MBS, student loans, and credit card debt?

  8. Mr. Beach commented on May 6

    Someone on Roubini’s blog pointed out Bernanke’s speech here from 2002: http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021121/default.htm

    Read this speech, over and over again. Then read it again. Some choice quotes from the speech:

    • When inflation is already low and the fundamentals of the economy suddenly deteriorate, the central bank should act more preemptively and more aggressively than usual in cutting rates.
    • Of course, the U.S. government is not going to print money and distribute it willy-nilly (although as we will see later, there are practical policies that approximate this behavior) .
    • To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys
    • Alternatively, the Fed could find other ways of injecting money into the system–for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities. Each method of adding money to the economy has advantages and drawbacks, both technical and economic.
    • If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.
    • On controlling long term yields: A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields.
    • Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years.
    • Yet another option would be for the Fed to use its existing authority to operate in the markets for agency debt (for example, mortgage-backed securities issued by Ginnie Mae, the Government National Mortgage Association).
    • If lowering yields on longer-dated Treasury securities proved insufficient to restart spending, however, the Fed might next consider attempting to influence directly the yields on privately issued securities.
    • …would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral.14 For example, the Fed might make 90-day or 180-day zero-interest loans to banks, taking corporate commercial paper of the same maturity as collateral. Pursued aggressively, such a program could significantly reduce liquidity and term premiums on the assets used as collateral. Reductions in these premiums would lower the cost of capital both to banks and the nonbank private sector, over and above the beneficial effect already conferred by lower interest rates on government securities
    • The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt.
    • A striking example from U.S. history is Franklin Roosevelt’s 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934.17 The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt’s devaluation.

    Reading this just makes me vomit.

  9. Tobias commented on May 6

    Let the market determine interest rates, not a group of private bankers!
    The Fed is antidemocratic and unconstitutional. It is the Fed that creates the booms and busts! I’m afraid it will take a global collapse of the banking system and a greater depression before people become aware of this.

  10. Winston Munn commented on May 6

    This is slighly off topic but I just read this quote and had to share my horror.

    Mish Shedlock reports,

    “Last week, Federal Deposit Insurance Corp. Chairman Sheila Bair proposed that Congress authorize the Treasury Department to make loans to homeowners to help pay down as much as 20 percent of their mortgage principal.”

    My God, she wants to nationalize the liar loans to save the property values from further decline!

    There is some serious panic out there that has not been marked-to-market.

  11. David Merkel commented on May 6

    I’ve been talking about it a little:

    http://alephblog.com/2008/05/03/half-a-dozen-thoughts-on-monetary-policy/ (point 4)

    A few journalists have called me about it as well… it does change things, at the risk of the Fed potentially becoming unprofitable if it pays a lot of interest while taking on instruments that have credit and possibly prepayment risk.

    But if that happens, it costs the US taxpayers money through reduction of the seniorage profits that the Fed pays the Treasury, which I talked about at the end of this post.

    http://alephblog.com/2008/04/29/sternly-bashing-the-bear-stearns-bailout/

  12. Pat G. commented on May 6

    “We’ve traded simple commen sense for a ton of bad math and theory.”

    I didn’t trade anything. It was taken from me while I was busy keeping my nose to the grindstone while others “in charge” were exploiting my efforts due to their perverse greed. When the aftermath is finally over, I hope this country wakes up and realizes that its not unlike a stock market analogy. More shares of a company are collectively owned by individuals yet they have the least to say about how the company runs its business. Our problem as I see it; we don’t have the money to influence the right people and are too divided amoungst ourselves to pose them any real threat. In the meantime, we allow ourselves to be distracted by their sideshows which is merely designed to confuse us over what the real issues are.

  13. Ken H. commented on May 7

    I’ve said this before Shrek. I think their moron’s as much as the rich folk on the titantic were when they locked the poor in the bottom. They knew it wouldn’t hold them forever,…just long enough to get the last life boat seats.

    I’ve read a couple of his paper’s and they read like the U.S. is in a vacuum. There are so many variables that cannot be accounted for so I hope he is fast on his feet and doesn’t fold like a lawn chair.

    I still say this was planned to deal with China and their ability to control our currency. They can’t crash the dollar if we do it first!! All I’m saying is they can play the moron card but I’m not buying it.

  14. Rich Shinnick commented on May 7

    Asked an acquaintance of mine who got a “liar” ARM back in 05-what are you going to do when the loan resets. His answer: refinance-these affordability loans are the “new way.” What if the “old way” comes back I said. “The government will have a program” he said. I said: “no way is the government going to bail out people on homes they can’t afford.”

    What an idiot I was.

  15. brion commented on May 7

    “I’ll bet this sort of stuff never even entered your thinking . . .
    ….but I have a sneaking suspicion that it will find a way to enter my wallet.”

    OH SNAP!
    that about says it all doesn’t it?

    can’t we just fast forward to Default?
    or would that not give everyone enough time to relearn how to work with oxen?

  16. shrek commented on May 7

    The vacuum issue is a problem for the whole world. CBs operate to promote differnt domestic policy goals, but in a globalized world everyone feels its. Its easy to make the case that China played a large part in the housing bubble by becoming a massive buyer of treasuries and keeping rates really low. Now they have a massive inflation problem because they refuse to let the RMB appreciate. Its the unforseen and unintended consequences that matter. Bernake is worried about the banking system, but should we be more worried about massive political and social risk that could develop because of rising prices for basic goods?

  17. DavidB commented on May 7

    “I’ll bet this sort of stuff never even entered your thinking . . .”

    ….new levels of corruption seldom do

  18. KJ Foehr commented on May 7

    Re: Ben’s speech excerpted above.

    I think it is apparent from Ben’s speech that he really believes he can control the economy to such an extent that a very serious recession / depression need never occur. To me this is overconfidence, and I think we are seeing that overconfidence now.

    I really think Ben and Hank and the boys believe they have things under control now; complacency has crept into their thinking. Yes, they are still increasing the liquidity being pumped into banks, but they have taken their eye off the real economy. And as they work furiously to save Wall Street, Main Street is flatlining.

  19. William Polley commented on May 7

    “Have you ever even thought about this?”

    I sure have, Barry. Lots of economists have. In fact, I seem to remember going to a talk once where it was discussed (though I cannot remember where or when).

    Don Kohn talked about it in 2004.

    http://www.federalreserve.gov/boarddocs/testimony/2004/20040622/default.htm

    I even blogged about it (with a reference to a paper) in 2006.

    http://www.williampolley.com/blog/archives/2006/11/fomc_minutes_7.html

    So yeah, I’ve thought about it.

  20. Darkness commented on May 7

    “All these stupid ideas are going to buy us what? Another year.”

    All it has to save is GW Bush’s legacy. Given all the blood, sweat and tears already expended on said effort (like trashing the constitution) this seems incidental.

  21. SR commented on May 7

    Other Central Banks already do it

    Australia’s RBA pays 25 under the Target cash Rate, & NZ’s RBNZ 50 under I believe

    Not the same scale as the USA of course, but generally things work reltively well in the AUD market.

    Compare USD LIBOR vs OIS, as opposed to AUD BBSW vs OIS. On this basis AUD is cheaper than many currencies. Would put this down partially do the RBA system (in particular term OMO activities), and the smaller reginal nature

    I’d expect that the FED would be use the below as part of a package that allows them to increase their effective loans from 1mnth, out further. Possibly via Repo’s

  22. KnotRP commented on May 7

    Mr. Beach – good post. One comment on the content:

    > If lowering yields on longer-dated Treasury securities proved
    > insufficient to restart spending, however, the Fed might next
    > consider attempting

    The government can overpay for all the assets it wants to, but that isn’t going to restart spending if most people don’t have any assets to be purchased. What’s everyone gonna do?…make those adjusted ARM payments while they wait for the Fed to come overpay for their home?

    The operative theme is attempting to push on a string,
    when the string isn’t even attached to the 70% of gdp consumer…it’s attached to folks who have savings and assets, who are unlikely to waste it. I sense wealth is about to up and leave the country, if it hasn’t already.

  23. Steve Barry commented on May 7

    Good comments tonight.

    Shrek said it all.. trying to stabilize housing at these levels is pure insanity. We need Volcker back.

    The no volume QQQQ rally continues as sentiment nears Euphoria. Can’t help wondering though what point oil has to hit to cause a non-linear market event? We are well past any point I would have postulated a few years ago. What say ye? 150? 175? I think we are nearing it.

  24. KnotRP commented on May 7

    Seriously – they might as well just cut ever citizen with a SSN a $1M check….at least that’ll end up in the hands of consumers too.

  25. KnotRP commented on May 7

    In case anyone mistakenly thinks I think that $1M check is
    a good idea:

    After they cut that check, thus devaluing all prior debts to the point of default, I wish us all good luck in trying to get anyone to save let alone lend in dollars. Kiss dollar based transactions goodbye.

    The Fed tried to inflate out of 2002, but didn’t pay attention to real wages in a globalized workforce. Instead, we inflated the BRIC economies. Ours is largely stagnant. Oops.

    Now they will attempt to inflate by overpaying for assets from wealthy people. Wonder o wonders, our economy will still be
    stagnant.

    Monumentally stupid.

  26. concerned commented on May 7

    I am looking for some help here … I am operating under the assumption that erosion of the dollar and continued printing of money will be the dominant factors in the foreseeable future.

    So with that in mind, I am hedging with swiss francs – or specifically, the FXF ETF. It’s done very well for me since end of q3 last year. My thoughts were that it got me out of the dollar, it positions me to benefit if whatever is left of the swiss carry trade unwinds, and keeps me from holding a (possibly) overbought Euro.

    So, any comments on swiss francs as a dollar inflation hedge now and going forward – especially if there is greater turmoil and possibly more extreme dollar drops in the future ?

    Is there some particular risk that the swiss franc exposes me to that I am perhaps not aware of ?

    All comments greatly appreciated.

  27. Troy commented on May 7

    So when banks lend 9:1 against these reserves, how is the money created? Do the banks have to pay interest on this money creation? At what rate and to whom?

  28. Peter commented on May 7

    Surprized nobody has mentioned that this decision could make the credit crisis worse.

    If banks can get guaranteed, safe, interest from the Fed, why would they want to lend this money out for a barely higher, but much riskier, interest rate?

  29. Egg commented on May 7

    Maybe it will also encourage banks to encourage depositors to save more??

  30. Uncle Jeffy commented on May 7

    Sure it’s entered my thinking – as it has the thinking of my Macroeconomics students every semester since I started teaching again (part-time – in the “real” world I work in a position akin to, but lower on the food chain than, BR). If you want to incent bankers NOT to make loans, it strikes me that one of the best ways to do it is to pay interest on reserves. Of course, with reserve ratios as low as they are, I don’t know how much of an effect we’re talking about.

    As far as “paying” for this stuff, it seems that people are operating under the idea that the Fed has to worry about revenues, profits, etc. But in reality, you just enter a credit to the reserve account of the bank and a debit to the “expense” account for “Interest Paid on Deposits”. See? “Money for nothin’, chicks for free…..”

  31. Bud commented on May 7

    Sounds like another tax to me

  32. mark1 commented on May 7

    The FED is increasingly delinking any vestige of relationship between the quantity of money and the price of money.

    If the FED pays out the funds rate on reserves, then the FED will have cart blanche to increase reserves at any quantity with no market mechanism to indicate that the overnight rate is too high vis-a-vis the supply/demand for reserves.

    This is very bad monetary and economic policy.

    But it’ll save the system… for today.

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