The Fed's Quiet Power Moves
For a central banker, the most important parts of the job can be the most arcane. Federal Reserve Board Chairman Ben S. Bernanke drew few headlines when he sent a brief letter on May 13 to Speaker of the House Nancy Pelosi (D-Calif.) and four other congressional leaders about a seemingly obscure housekeeping matter. He asked Congress to authorize the Fed to pay interest to banks on the money they keep on deposit at the central bank, beginning immediately; under current law, the Fed can't pay interest until 2011.
Bernanke's request could be a big deal. If approved it will set in motion a chain of events that could increase the Fed's flexibility and power in ways that many economists—and members of Congress—have yet to comprehend. It's part of his campaign to help ailing banks without spoiling the Fed's other mission, which is to control inflation. Once again, the mild-mannered Bernanke is forcing authors to rewrite their economics textbooks.
Whether or not you favor increasing the Fed's muscle depends on how much you trust the central bank to do the right thing. Supporters say it's important to take the handcuffs off so the Fed can do whatever is necessary to prevent a credit crunch from setting off a generalized economic collapse. Skeptics say it's a mistake for the Fed to keep taking junky securities as loan collateral, putting taxpayers at risk to bail out bankers who made dumb loans and investments.
In the blogosphere, some critics favor limits on the Fed's flexibility. "Let’s not write the Fed a blank check," finance graduate student Steve R. Waldman posted this month at his widely followed Interfluidity blog.
Columbia University economist Michael Woodford, a monetary policy expert, sees merit in both positions: "I see the advantage to the Fed having that flexibility if it's used properly. I also agree that there's an issue as to when it's right to use that power." House Financial Services Committee Chairman Barney Frank (D-Mass.), has said he's "favorably inclined" toward Bernanke's request.
How could a simple thing like paying interest on reserves have such wide-ranging effects? It's a bit complicated, but plays out something like this: U.S. banks relend most of the money they receive in deposits, but they have to hold a certain percentage in reserve for safety. These funds, consisting of either cash in their own vaults and ATMs or deposits at the Fed, earn no interest. If banks could earn interest on their reserves at the Fed, they'd probably be willing to keep more money there. They could sell some of the Treasury bonds and bills they own to the Fed and put the proceeds in their reserve accounts. Or they could deposit more of their vault cash at the Fed, which would use the money to buy Treasuries.
Either way, the change would give the Fed something it dearly needs—a bigger stash of Treasury securities to support its role as a lender of last resort. In fighting the credit crunch, the Fed has been exhausting its vast trove of Treasuries in recent months. It has lent nearly $140 billion worth to banks in exchange for relatively iffy assets such as mortgage-backed securities. In addition, so far this year it has sold $234 billion worth of Treasuries outright to soak up some of the excess money in the financial system created by its emergency lending to weak institutions.
Mum on How Much
The Fed has sought permission to pay interest on reserves for years. In 2006 it got congressional approval to start in October, 2011. But that's not soon enough for Bernanke, because he suddenly needs more tools to deal with the credit crunch.
The Fed is refusing to say how much it might pay on reserves. That's crucial to know, and not just because it will affect the cost to taxpayers. If the Fed pays a token amount, banks won't have much incentive to adjust their behavior and little will change. If it pays a lot, reserves could increase dramatically. In congressional testimony in March, 2006, Fed Vice-Chairman Donald L. Kohn raised the possibility that the Fed wouldn't even need to set a requirement for reserves because banks would hold plenty voluntarily.
"Not a Huge Deal"
In the extreme, the Fed could even use the rate it pays on deposits to steer bank lending directly: Raising the rate would encourage banks to make fewer loans and stash their money at the Fed instead, while lowering it would induce the banks to reserve less and lend more.
The Fed could clearly use some better instruments for managing money. Lately, the federal funds rate on overnight loans of reserves between banks, which is targeted to be 2%, has dropped to near zero for brief periods. That should stop if the Fed starts paying interest on reserves, because banks will be happy to hold reserves above the regulatory minimum instead of lending them out for a pittance. Stability in the federal funds rate matters because it influences other short-term rates and thus the economy.
Most central banks already pay interest on reserves, so in one sense the Fed is simply playing catch-up. "I think it's not a huge deal," says Stephen G. Cecchetti, a finance professor at the Brandeis University International Business School and former research director at the Federal Reserve Bank of New York. But other experts say the impact would be greater in the U.S. because it would let the Fed expand its already considerable credit resources. What's clear is that Bernanke is seeking yet another weapon for an already formidable monetary arsenal.