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Thread: Fed Paying Interest On Reserves Question

  1. #1

    Default Fed Paying Interest On Reserves Question

    The fed is going to start paying interest on reserves it holds for banks. Apparently this is a way for the banks to self-sterilize as the fed's ability and the treasury's ability wanes. The mechanism works basically like this: the fed injects new liquidity into system, if the effective fedfundsrate drops below the interest rate paid on reserves, banks will put it's money into its reserve account to earn positive carry and reducing money in circulation.

    Presumably this will allow for a huge amount of liquidity to be added to the system WITHOUT increasing the monetary base. If the fed were to continue to buy lesser quality assets, the fedfunds rate will decrease as the money enters circulation, however as the fedfunds rate dips below the interest paid on reserves, banks will simply push all that money into reserves, eventually ballooning the reserve account well beyond required.

    So the monetary base will increase enormously as banks increase interest paying reserves but at the same time, that money will not be subject to fractional reserve multiplier in circulation. I'd compare this to the Supplemental Financing Program by Treasury where it sterilized $200B by auctioning off tbills and depositing proceeds at the Fed.

    Final result: It seems like this allows the Fed to massively increase its facilities to banks while not having to sterilize using its balance sheet or having the Treasury increase its debt. Ultimately looks like the Fed is financing the facilities at the interest rate paid. Is this analysis correct?



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  3. #2

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    I'm getting to the same conclusion as you, but the question I have is do banks HAVE to put this money in reserves? I mean the only way I see them doing that is if the interest rate is higher. Are they allowed to use this money and invest elsewhere? Which would then require them to use the FR multiplier.

    Do you have any links on this? I would love to read a little more about it.
    Privatize the profits, socialize the losses. - Government at its best.

  4. #3

    Default Very good piece on bank sterilization

    http://acrossthecurve.com/?p=1731

    To further the analysis, if this bank sterilization works, the Fed can monetize bad assets ad infinitum, while ballooning reserves held at the bank (including monetary base) but that base won't be multiplied since it won't be lent out.

    Banks will give up profits on the multiplier effect in exchange for safer balance sheets all backstopped by the Fed. How will the Fed pay that interest? Probably come out of interest it earns on asset side of b/s. I'm guessing at this point.

  5. #4

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    hmmmm...The only way this will work is if banks absolutly deposit at the Fed. If there is no obligation then what would stop any bank from taking risk to increase profit? I only see this working for banks who are close to insolvency and therefore cannot take anymore risk.

    But since insolvency is the case for most banks this actually might pay off.
    Privatize the profits, socialize the losses. - Government at its best.

  6. #5

    Default

    Quote Originally Posted by icon124 View Post
    hmmmm...The only way this will work is if banks absolutly deposit at the Fed. If there is no obligation then what would stop any bank from taking risk to increase profit? I only see this working for banks who are close to insolvency and therefore cannot take anymore risk.

    But since insolvency is the case for most banks this actually might pay off.

    Right. But due to the fact that we're in a deflationary environment and that credit risk is growing due to a recessionary trend, banks wouldn't be lending that much anyway so a loan to the fed backed by the taxpayer would be highly desirable.

    On a more macro level, I'm wondering if other central banks would be alarmed at the inflationary increase in reserves tho this concern would be mitigated by the lack of multiplier effect.

  7. #6

    Default

    How it will change...

    CDS = FDS aka FEDERAL DEFAULT SWAPS
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