Unlawful interest?

In October 2008, as the financial crisis reached a fever pitch, the Fed started paying interest on banks’ reserves. The rate is very low, 0.25%, but it turns out that at this point in the Lesser Depression, with short-term interest rates even lower (the 3-month T-bill rate is 0.02%, and the 6-month rate is 0.06%), the Fed might actually be breaking the law by doing this. David Glasner of the Uneasy Money blog has a fascinating post about it.

According to Glasner, the Financial Services Regulatory Relief Act of 2006 allowed the Fed to pay interest on reserves but specified that the interest rate on reserves not “exceed the general level of short-term interest rates.” Normally that’s not a problem, and even in October 2008 the 3-month T-bill rate was well above 0.25%. But a month later, as the crisis deepened and panicked investors sought safe haven in T-bills, the rate fell below 0.25%, and there it has stayed ever since (except for a few weeks in 2009).

So if Glasner has interpreted the law correctly (and in typically modest fashion he does not claim to understand it perfectly), the Fed is breaking it. I am absolutely not a Fed basher: the Fed was not breaking the law back in October 2008; it was the worldwide flight to safety that caused short-term Treasury rates to fall to near zero the next month and stay there;  and Congress, despite passing that act in 2006, has not seen fit to call the Fed on the carpet on this one. Which suggests that the drafters of this act recognize the extraordinary circumstances of this financial crisis and regard the Fed’s payment of above-market interest rates on reserves as a non-problem, not even enough of a problem to warrant revising the act to allow it. As long as nobody noticed (until this month anyway), why bother?

My opinion may sound contradictory, so I’ll break it into two parts.

  1. I think Congress should revise the law to allow the Fed to pay higher interest rates on reserves, as they may need to if the economy starts to recover rapidly and banks open the floodgates by rapidly loaning out their excess reserves. Fed Chair Ben Bernanke has spoken of how the interest-on-reserves tool allows the Fed to “soak up” banks’ excess reserves before inflation starts to rage, and that may require higher-than-market interest rates on reserves.
  2. But we’re nowhere near that point now. We’re still in a depression, and it makes little sense for the Fed to be paying banks to keep their reserves idle instead of loaning them out. I recognize that part of the rationale for interest on reserves is to keep the banks from tying their reserves up in T-bills instead of loaning them out, but with T-bills paying close to zero interest, that seems unlikely to happen. In the current depression banks have been loading up on T-bills and reserves. Even if they did put more of their reserves into T-bills, that doesn’t exactly tie them up:  T-bills are the most liquid assets in the world (they’re often called “secondary reserves”) and banks could easily liquidate them if profitable loan opportunities came along. Right now, I’d say the appropriate interest rate on reserves is 0%.

Would lowering the interest rate on reserves from 0.25% to 0% spur a lot of lending? Doubtful, but it would likely make a difference at the margin in some cases, causing at least a few more loans to be made and a few more jobs to be created. Small potatoes, yes, but I don’t really see a downside here. It would also take some populist pressure off the Fed, which, as a giant financial institution, isn’t terribly popular these days, either among Republicans or among Occupy Wall Streeters. The man on the street is not pleased to hear that the Fed is paying banks interest on the money they don’t use.


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