Maybe we should be grateful the proposed Tarp/EESA didn’t make it through Congress, since we’ve just noticed this part:
Section 128. Acceleration of Effective Date.
Provides the Federal Reserve with the ability to pay interest on reserves.
The Fed’s due to start paying interest on reserves in 2011. The EESA in the form above would have accelerated that start date in a bid to improve liquidity and prevent this, in the Fed funds rate (from Bank of America yesterday):
You can see, it starts out quite high every day as banks hold back cash amid uncertain financing needs, according to BofA. Towards the end of the day, as those needs become more clear, it falls. Banks want to put their cash to work and avoid having it sit around not earning interest (as difficult as that might be in the current environment).
In theory, if the Fed started paying interest on those reserve requirements it could provide a floor to the rate as banks would be more willing to keep excess reserves at the Fed. It’s an idea that’s been mulled over for some time, originally as a way of improving the Fed’s liquidity abilities without running out of Treasuries or printing more money (sterilisation).
From the FT in April:
Currently, the Fed cannot expand or contract its balance sheet without altering the overall supply of reserves and changing its main policy rate, the Fed funds rate.
All it can do is change the composition of its balance sheet – absorbing more duration risk, liquidity risk or credit risk from the private sector.
But if the Fed was able to pay interest on deposits, it could use that rate to put a floor under the Fed funds rate.
That would free the US central bank to conduct liquidity operations that were larger than the size of its current balance sheet – roughly $800bn.
‘The point…would be to allow the Fed to expand its balance sheet without having to drive the fed funds rate to zero in the process,’ said Goldman Sachs.
That’s fine in theory, except that Tarp wanted to use reserve interest as a way of encouraging interbank lending. As EconWeekly noted some time ago, that may well have backfired:
Reserve balances are like checking accounts: they don’t earn interest. For that reason banks have little incentive to hold more reserves than they need to meet the Fed’s requirements and clear transactions. Any excess reserves are loaned to other banks…
This measure would lead to a higher equilibrium level of reserve balances, for a given value of the federal funds interest rate. It would also reduce the amount of inter-bank lending, as banks would keep more of their cash in their safe-deposit box at the Fed. That lending would be replaced by loans from the Federal Reserve.
At least we don’t need to worry about it now…