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Today, the House Financial Services Committee Subcommittee on Monetary Policy and Trade held a hearing entitled: “Interest on Reserves and the Fed’s Balance Sheet.” Although the hearing did not directly mention credit unions, it featured a panel of expert witnesses and an illuminating discussion of recent changes in monetary policy implementation. Several of the questions from members of Congress were related to concerns that these changes have affected the availability or distribution of credit.
These changes in monetary policy implementation emanate from the financial crisis of 2008. As the crisis was worsening, the Fed faced a conundrum. Through its various new/expanded crisis- lending facilities (discount window, TALF, Corporate paper facility, etc), the Fed was adding trillions of dollars of reserves to the banking system, but it still had an overnight interest rate target above zero. Having run out of unencumbered Treasury securities to sell off its portfolio in order to drain these added reserves and support its interest rate target, the Fed needed a new tool.
The Financial Services Regulatory Relief Act of 2006 had authorized the Federal Reserve Banks to pay interest on balances held by or on behalf of depository institutions at Reserve Banks, subject to a rulemaking by the Board of Governors, to be effective October 1, 2011. The effective date of this authority was advanced to October 1, 2008 by the Emergency Economic Stabilization Act of 2008, and a rule amending Regulation D was finalized just a week later.
Regulation D is written to limit the liquidity of savings accounts by only allowing a certain amount of monthly withdrawals from time to demand accounts. Reg D also imposes reserve requirements on depository institutions, which was intended as a tool for managing the supply and price of bank money. These requirements created a continuous demand for central bank money (reserves) above and beyond what was needed for interbank payment settlement. Therefore by creating demand, the Fed as the monopoly supplier of reserves could control the price of these reserves and therefore the profitability of bank lending.
So in October of 2008 the Fed gained the ability to pay interest on reserve balances, a power which it previously did not have. This allowed the Fed to establish a non-zero overnight interest rate without having to conduct any open market operations. With the floor of interest rates now solidly in place, the Fed could continue lending emergency reserves into the banking system while simultaneously maintaining a nonzero federal funds rate. Interest on Reserves (IOR) changed the game in the federal funds market, and trading volume decreased significantly, by about 75%.
The 2008 changes to Regulation D reduced the need for reserve requirements. Since the Fed now has the ability to pay interest on reserve balances, it can “sterilize” a certain percentage of the monetary base simply by incentivizing banks to move balances out of the federal funds market and into interest bearing reserve accounts, known as “excess balances accounts”. In this way, the rate paid on reserve balances serves as a floor to short term interest rates, and the rate charged for institutions that borrow reserves from the Discount Window or through overdrafts represents a ceiling on short term rates.
So with this monetary incentive in place, there is little need to require banks to hold a certain amount of reserves through regulation. Under the IOR system, no regulatory requirement is needed to create a demand for reserves (although even with no IOR banks would still need to hold reserves to meet payments).
Concerns that implementing monetary policy by increasing the rate paid on reserves represent an increased cost to the government are unfounded. While it is true that the interest the Fed pays on reserves is subtracted from what it would otherwise remit to the Treasury, the Treasury ends up ‘paying’ either way. If the Fed were to raise interest rates by selling off part of its Treasury portfolio, as it has done in the past, then its earnings, and therefore remittances to the Treasury, would decrease by about the same amount, and the yield on new Treasury offerings would rise.
In fact, it is likely the case that banks end up earning less under the IOR scenario, since the reserves earning 25 basis points replaced the Treasury securities earning anywhere from 50-200 basis points. Therefore, the size of the Fed’s payments to the Treasury depend on the size of its portfolio, not on the method used to raise interest rates.
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