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A New Implementation
of Monetary Policy?

Since the early 1980s, implementation of monetary policy by the Fed has meant setting a target for the overnight interest rate on interbank loans, and continually adjusting the supply of reserves in the banking system to match the aggregate demand at its target interest rate.

That came to an end in 2008 when the Fed initiated the so-called Quantitative Easing (QE) program. QE involved the purchase of large amounts of securities from the public, thereby inundating the banking system with excess reserves (Fed funds). As a result, the Fed funds rate promptly dropped to nearly zero interest rate where it has stayed for more than two years. At about the same time, the Fed also began paying interest on Fed funds at 0.25% per annum.

Excess reserves and the "floor system"

At some point the Fed will need to increase the target interest rate on interbank loans by several percentage points to prevent an overabundance of credit money due to bank lending at unusually low interest rates. With more reserves than banks desire to hold, the only way it can do that is to increase the interest rate it pays on reserves. That sets a floor below which banks have no incentive to lend in the interbank market or to issue loans to the public. There is no way to return to the former method without recapturing the excess reserves, which means selling the securities it bought under QE. The Fed may very well decide to adopt the “floor system” on a permanent basis because it has certain advantages over the current system.

A floor system would give the Fed an additional degree of freedom in setting monetary policy.  With enough excess reserves, the effective interest rate could be set independent of  the quantity of reserves in the banking system. That would give the Fed the freedom to address potential liquidity problems in the financial system with additional reserves without affecting the short-term interest rate.

In the current system, before excess reserves were remunerated, banks held as few reserves as possible because they were non-earning assets. However the amount of reserves banks need for clearing purposes at the Fed is typically much greater than the reserves they normally hold. Banks therefore have to borrow from the Fed during “daylight” hours to cover their payment obligations. That requires pledging collateral or paying interest on the loans. With a sufficient level of excess reserves in the banking system, the amount of daylight borrowing could be substantially reduced and simplified.

Potential problems with the floor system

On the other hand, when excess reserves are remunerated, the pressure on banks to participate in the interbank lending market is reduced. That works to the disadvantage of smaller banks. Some way of inducing large banks to lend their excess reserves would be needed. There are various ways of doing that. One would be to reduce  the interest rate paid by the Fed on a bank’s excess reserves above a certain level relative to its average daily transactions. Above that level, banks could earn more by trading in the Fed funds market.

The Fed normally refunds to the Treasury its income in excess of its own expenses. Since paying interest on reserves would reduce its net income, the amount refunded to the Treasury would likewise be reduced. Other things equal, that means the Treasury would have to make up difference with additional borrowing.  However the amount would be relatively small, probably in the range of ten to twenty billion dollars per year.

Are interest payments a free lunch?

The question arises whether paying interest on reserves is a free lunch for the banks that acquired the excess reserves simply as a result of the Fed’s purchase of securities for QE. If a seller of the securities left the proceeds on deposit, his bank would enjoy a free lunch. However its value to the bank would depend on the interest rate it had to pay to retain the depositor.  Since a bank would have a guaranteed profit at any interest rate below that paid by the Fed, it is likely that competition among banks would leave most of the benefits to the depositors rather than the banks.  

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