Friday, November 28, 2008

Fed set to pay interest on banks' deposits

According to the May 8, 2008 article "Fed set to pay interest on banks' deposits" in The Independent, the U.S. Federal Reserve System is adding a new tool to monetary policy: the ability to pay interest on deposits at the Fed. When commercial banks deposit money in accounts at the Federal Reserve System, that money is not available to be loaned to the public. The Fed can alter the amount of money in circulation by altering the interest rate on deposits to influence how much money is loaned to the public. According to writer Stephen Foley:
The Federal Reserve is adding another weapon to its armoury for dealing with the credit crisis, with plans that would allow it to pay interest on deposits from thousands of US banks.

The scheme, which the Fed chairman, Ben Bernanke, is requesting permission for from Congress, is the latest in a series of innovations designed to help the central bank keep credit markets moving – efforts for which it has so far been roundly praised.

All of the country's commercial banks are required to keep a proportion of their cash at the Federal Reserve in order to ensure their solvency, but they do not currently receive interest. Paying interest will give the Fed an important lever for controlling interest rates throughout the financial system. Congress has agreed to allow the Fed to do so, but there was concern about the costs to the taxpayer, and the law will not take effect until 2011. Mr Bernanke is pressing lawmakers to remove the delay.

Paying interest would in effect set a floor for market interest rates, since banks would have no incentive to lend cash at a lower rate than it can get from the Fed. That means the Fed can flush the financial system with new money, without risking interest rates collapsing and setting off inflation.

Since the credit crisis began last summer, the Fed has made a series of seemingly arcane, but important changes to the way it interacts with financial markets. It has expanded the collateral it will take in when making new loans, acted to remove the stigma for financial institutions borrowing from the Fed and – most importantly – begun lending directly to Wall Street firms as well as just to commercial banks.

No comments:

Post a Comment