Monday, April 28, 2008

fed to discuss interest on bank reserves

On the Federal Reserve's Web site, there is a notice indicating that the Fed will consider the "implications of interest on reserves for monetary policy implementation." The notice appears in the section on "board meetings," which contains information on the regularly scheduled meetings of the board of governors, which tend to be held once every two weeks.

In this particular case, the matter to be considered before the board will coincide with the decision on interest rates, a further sign of the Fed's intent to use as many tools as possible to help the financial system. It is worth noting that the idea of paying interest on bank reserves has been around a long time and was recently approved by the Congress.

Over 40 years ago, Milton Friedman proposed the idea, and it was pushed for many years by Fed Chairman Alan Greenspan before it was approved in September 2006. Interest on reserves will first be paid beginning Oct. 1, 2011.

There are a few benefits to paying interest on reserves. In particular, doing so removes a very significant burden on banks by removing the need for banks to constantly monitor their reserve levels in order to avoid the opportunity costs that come with leaving reserves on deposit at the Fed and earning no interest. The second benefit is obvious: Banks will earn money on their capital rather than earn nothing. Banks currently hold about $42 billion of reserves at the Fed (by reserves, we are of course referring to the monies that banks set aside as required by the Fed for the deposits they hold).

A third benefit of paying interest on reserves is that banks will be inclined to hold more money at the Fed than otherwise, creating more soundness for the banking system. In other words, "payment risks" would be reduced, with banks having more cash on hand than otherwise.

It is interesting that this issue is being brought up now. It could be a coincidence, or it could be another sign of the Fed seeking as many ways as possible to fortify the financial system.

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