One Bank Handout the Fed Should Keep Giving

(Originally published here.)

Many people who should know better have been confused by the Federal Reserve’s decision to pay 0.25 percent in annual interest on reserves held on deposit by member banks. Robert Hall, a senior professor at Stanford, for example, argues that “an expansion of reserves contracts the economy” when the Fed pays interest on reserves.

Perhaps in response to these arguments, some people at the Fed are starting to consider reducing the interest rate they pay to banks for holding deposits at the Fed. That would be a mistake. Lowering the interest rate on reserves could destabilize the financial system, weaken the economy and inadvertently cause banks to shift to more volatile funding sources.

Two sentences in the minutes of the latest meeting of the Federal Open Market Committee hint at a possible policy shift:

Participants also discussed a range of possible actions that could be considered if the Committee wished to signal its intention to keep short-term rates low or reinforce the forward guidance on the federal funds rate. For example, most participants thought that a reduction by the Board of Governors in the interest rate paid on excess reserves could be worth considering at some stage, although the benefits of such a step were generally seen as likely to be small except possibly as a signal of policy intentions.

Intriguingly, the minutes mentioned no discussion of the potential costs of lower interest rates, even though Fed Chairman Ben Bernanke and his presumptive successor, Janet Yellen, have both warned that interest rates closer to zero could disrupt short-term funding markets. (Cardiff Garcia at Alphaville cautiously suggests that the Fed’s new reverse repurchase facility could one day be used to offset small reductions in interest paid on reserves, but is quick to note that the tool isn’t ready yet.)

There are other reasons to be wary of lower interest on reserves. The Financial Times reported that several bankers whom it didn’t identify warned they would have to start charging depositors fees just to keep money in checking accounts if they lost the interest income they got from the reserves they hold at the Fed. Offering deposits isn’t costless for banks, which have administrative expenses and run much of the infrastructure behind the payments system. Banks also have to pay fees to the Federal Deposit Insurance Corp. commensurate to the value of the deposits they borrow from savers. (Some at the Fed might actually be hoping for this outcome if it made saving less attractive compared with spending.)

Even though the banks’ threats are probably bluster, a lower rate of interest on reserves would still be bad for the economy. Banks would have to respond to the cut in revenue even if they didn’t raise fees on depositors. They might lower salaries, raise interest rates on new loans, or engage in riskier trading strategies. Banks might also choose to reduce their reliance on deposits as a source of funding, instead preferring to raise money in the volatile capital markets. None of these things would be helpful to the broader economy.

Given these known costs and the small, uncertain benefits, the Fed should avoid experimenting with the rate paid on reserves.

(Matthew C. Klein is a writer for Bloomberg View. Follow him on Twitter.)

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About Matthew C. Klein

I write about the economy and financial markets for Bloomberg View. Before that I wrote for The Economist on a fellowship provided by the Marjorie Deane Financial Journalism Foundation. I have worked at the world's largest hedge fund and read every FOMC transcript since May, 1987.
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