classical economics
for analysis,  forecasting
and policy design

Interest on Bank Reserve
By Wayne Jett
© May 9, 2008

    When the Federal Reserve Board proposes to modify its practices, the last place to look for the real reason is the Fed’s own statement. Why utter such disrespect for the Fed’s veracity? Because the lack of integrity of the Federal Reserve and the U. S. Treasury is remonstrated by the Fed’s devaluation of the dollar by two-thirds during the past five years. All the while, the Fed professed to be fighting inflation and Treasury declared to the world the “strong dollar” policy of the United States of America. They must crave disrespect.
    The Federal Reserve now asks Congress for authority to pay interest to its member banks on funds required to be held as reserves. This has never been done, so why should it begin now?
    To be fair in airing the issue, why not pay interest on bank reserves? Banks deposit reserves into the care of the Federal Reserve. Shouldn’t they be entitled to interest on their money while the Fed has it?
Reserves are Reserved from Risk
    But the Fed really does not have “use” of the reserve funds. Reserves are kept at the Fed for safety and security, just as the same reserves would be kept in the vaults of individual banks if the Fed did not exist. Reserves are kept free of any investment risk so each bank will assuredly have funds to protect its depositors against loss due to risks taken in the bank’s lending and investment operations. By their very nature, reserves do not earn investment return because they are not invested. The Federal Reserve does not invest those funds, putting them at risk in order to earn a return, so no interest is owed to the member banks on their reserves.
    Indeed, holding, protecting and accounting for the reserves are services that cost the Fed operating expenses. These expenses reasonably should be paid by member banks through fees to the Fed because the banks receive business benefits of added security for banking customers.
Who Pays the Bill?
    If permitted by Congress to do so, the Federal Reserve says it can afford to pay interest on the reserves from funds the Fed earns on its own portfolio of assets. Ordinarily those assets are Treasury securities, on which the U. S. Treasury pays interest. Recently the Fed has turned about half of those assets into various types of private debt instruments. The Fed receives interest earnings on those assets, spends what it chooses for its own operations, and is required by law to transfer any remaining balance to the federal Treasury. In 2007, for example, the Fed paid $34.4 billion to the Treasury from its earnings.
    In a very real sense, therefore, funds to pay interest to banks on reserves held for safekeeping would come from the U. S. Treasury, and the expense would add to the federal budget deficit. In context, the Federal Reserve proposes to pay banks to hold funds in reserve as security while the balance of bank capital is invested in loans and other banking business. And the U. S. Treasury would bear the cost. That does not sound well considered.
    The Federal Reserve acquires its portfolio by creating dollars for use in buying those assets. With this discretion, the Fed can always increase its portfolio and its earnings on assets, so long as it is willing to create more money and, perhaps, more inflation. The Fed could create more dollars to increase its portfolio and earnings enough to maintain its high level of yearly transfers of “free money” to Treasury and still pay interest on bank reserves. But Americans would wind up paying the bill anyway through the hidden tax called inflation. Bank reserves are not invested to earn return on the capital, so the only source of funds to pay interest on reserves is money creation, which inflates the value of all dollars.
Favoring Banks
    Maybe the Federal Reserve proposes paying interest to banks because banks are strapped for capital. The Fed recently acted emergently to pump $25 billion into Bear Stearns and an additional $30 billion into J. P. Morgan Chase Bank as an inducement to step forward and acquire Bear Stearns. Paying interest on reserves might calm agitation towards the Fed felt by other banks left out of such a unique opportunity as was given to Morgan Chase.
Fed Needs “Better Control”
    Having considered the range of motives likely to be influencing the Federal Reserve’s proposal, we finally come to the reason the Fed says it ought to pay interest on bank reserves. The Fed says doing so will enable the central bank “to gain better control over interest rates and more leverage to battle the credit crunch” since the funds rate would be “less likely to plunge below the Fed's official target -- now 2% -- on days when the banking system is awash in cash.” (Emphasis added.) These are the words of Greg Ip of the Wall Street Journal, who in most instances may be regarded as the Fed’s spokesman in financial media. In a word, this explanation is sophistry – pure and unadulterated.
     The funds rate target is a charade insofar as monetary policy is concerned, employed by the Federal Reserve to assist member banks in setting their prime interest rates anti-competitively. The funds rate is not the valve of dollar liquidity. This is proved yet again by the Fed’s own argument, which shows the Fed is perfectly comfortable with a banking system “awash in cash” so long as member banks don’t charge less for overnight loans of reserves than the funds rate target.
    Why does the Fed desire that the funds rate target be honored even when the system is awash in cash? Because, when the target rate is honored, one bank does not get a competitive advantage over other banks by negotiating a lower-than-target interest rate for borrowing overnight reserves. Again, the funds rate target is all about removing competition from banking. If the Fed were actually guiding liquidity by interest rate signals, it would view undercutting of the funds rate target as evidence liquidity should be drained, and would act accordingly.
    Moreover, funds rate manipulation is entirely incapable of stabilizing the dollar’s value. Nonetheless, manipulating domestic interest rates, asset prices, unemployment and economic growth are things the Federal Reserve insists upon doing, and people the world over suffer for it.
Forget Interest – Stabilize the Dollar
    In combination with the Federal Reserve’s less-than-transparent liquidity management, interest rate manipulation has produced severe dollar deflation (as during 1997-2002) and severe dollar devaluation (as during 2004-2008) during the past decade. To avoid continuing destructive cycles of this nature, the Federal Reserve should abandon interest rate manipulation and proceed by managing its asset portfolio to stabilize the dollar’s value relative to gold. This would satisfy every producer in the world that the dollar is trustworthy again, so long as the U. S. sticks by this essential reform.
    Federal Reserve governors, do your duty to strengthen and stabilize the dollar. Forget paying interest to banks on reserves that sound banking practice demands be held away from investment risk. End your use of currency devaluation as a weapon of trade war. Impoverished Americans and inflamed nationalism around the globe are not legacies you should cherish. ~