JPMorgan Re Interest on Reserves

September 29th, 2008 2:26 am | by John Jansen |

This is the JPMorgan take on the provison of the new law which allows the Fed to pay interest on reserves. It is a much clearer explanation than I offered earlier.
Tucked away in the details of the TARP legislation is a small clause that could revolutionize monetary policy-making in the US and dramatically increase the ability of the Fed to respond to the current financial crisis. The legislation which could go before the House tomorrow has a section that reads: “Section 203 of the Financial Services Regulatory Relief Act of 2006 (12 U.S.C. 461 note) is amended by striking ‘October 1, 2011’ and inserting ‘October 1, 2008’.” The act mentioned granted the Fed authority to pay interest on reserves beginning in 2011, the current legislation proposes to grant that power beginning this Wednesday.

This change would greatly increase the ability of the Fed to expand the size of its existing liquidity facilities. Under current procedures, any time the Fed has provided market liquidity by injecting reserves into the banking system — be it through the TAF, PDCF, discount window lending, lending to AIG, or other forms of Fed lending — the increase in reserves has had to be ‘sterilized’ by selling Treasuries, conducting reverse repos, or, more recently, through the novel route of having the Treasury overfund itself to increase its account at the Fed. Those means of sterilization threatened to run up against certain balance sheet constraints: the Fed now has less than $250 billion of Treasuries that it hasn’t lent out through the TSLF and TOP, and the Treasury’s overfunding could eventually bump up against the debt ceiling.

With interest on reserves, the Fed would not have to sterilize injections of reserves into the banking system. Normally, reserve injections need to be sterilized to prevent the fed funds rate from undershooting the FOMC’s funds rate target. With interest on reserves, wherever the Fed sets the rate on its deposit facility would effectively set a floor under the funds rate: anytime the effective funds rate would be below the deposit rate, banks would have an incentive to deposit excess reserves with the Fed. Excess reserves would be ‘sterilized’ by banks depositing them with the Fed.

One proposed operating procedure using interest on reserves, called the floor system or the Goodfriend system, would have the Fed set the deposit rate at the FOMC funds target rate and then inject massive amounts of reserves into the banking system — possibly by increasing TAF or similar facilities — and allowing the excess reserves to be deposited with the Fed at the target rate. Following such an operation, the Fed’s balance sheet would contain more risky assets and — on the liability side — more deposits (the monetary base would be roughly unchanged); the private sector’s balance sheet would contain less risky assets and more safe assets in the form of deposits with the Fed. The effect on the private sector balance sheet from the TARP is similar, though in that plan Treasury debt takes the place of Fed deposits.

The Fed has not discussed how soon they might implement interest on reserves, one obvious reason being that the proposed legislation hasn’t yet become law. Because this power would be granted roughly contemporaneously with the TARP, the Fed may choose to see how effective the TARP is before setting up a deposit facility as a tool to help address the credit crisis.
Michael Feroli
US Economist, JPMorgan Economics

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  1. 10 Responses to “JPMorgan Re Interest on Reserves”

  2. By Dr.Dan on Sep 29, 2008 | Reply

    Thanks JJJ.

    I think there is lot of politics being played around this one.

  3. By Dr.Dan on Sep 29, 2008 | Reply

    Glitnir bank @ Iceland seems to have gone belly up. Details awaited

  4. By Dr.Dan on Sep 29, 2008 | Reply

    I havent gotten a LIBOR quote yet but I got calls saying they are “off the scale”

  5. By Dr.Dan on Sep 29, 2008 | Reply


  6. By Dr.Dan on Sep 29, 2008 | Reply

    LIBOR/OIS: Dollar 3-mth LIBOR/OIS spread widens to 219.1bps vs 200bp Fri

    — Euro 3-mth LIBOR/OIS spread widens to 111.55bps vs 95.4bps Friday

    — Sterling 3-mth LIBOR/OIS spread widens to 151.9bps vs 149.6bps Fri.

    Sorry for stealing the show but this is such a good blog and I want to share as much as I can in these troubled times

  7. By Hubert on Sep 29, 2008 | Reply

    okay, what is the implication of this for LIBOR starting October?

    I am not a credit guy, so please forgive me if I am going astray:
    Banks now put their surplus funds at the end of the day presumably into a too big too fail bank which is still reasonably sound – that means JPM or BAC.
    Instead now they get interest from the Fed and the Fed takes this money (how much could that be?) and will do some swapping to get to Europe or into MBS or whatever?
    What can we conclude for LIBOR rates here?

  8. By John Jansen on Sep 29, 2008 | Reply

    libor is driven by fear and until JPM and BAC are comfortale with each other it will remain ugly

  9. By JohnGalt on Sep 29, 2008 | Reply

    Ow, my eyes! Why is the text on this page light gray on white background?

  10. By flow5 on Oct 20, 2008 | Reply

    A Tax???? A brief “run down” will indicate just how costless, indeed how profitable – to the participants, is the creation of new money. If the Fed puts through buy orders in the open market, the Federal Reserve Banks acquire earning assets, by initially creating new inter-bank demand deposits (IBDDs).

    The U.S. Treasury recaptures c. 97% of the net income from these assets (via SOMA). The commercial banks (collectively, or as a SYSTEM) acquire “free/gratis” legal reserves, yet the bankers complain (always have their hand in the cookie jar) that they are not earning any interest on their balances in the Federal Reserve Banks (IBDDs), i.e., that it is a regulatory burden [sic].

    So, if as the bankers & their collaborators say (this is a tax), then why is it, that when excess reserves are added by the FED, that the member commercial banks collectively expand loans & invest?

    On the basis of these newly acquired reserves, the commercial banks can, and do, create a multiple volume of credit and money. And through this money, they acquire a concomitant volume of additional earnings assets.

    How much is this multiple expansion of money, credit, and bank earning assets? Thanks to fractional reserve banking (an essential characteristic of commercial banking) for every billion dollars of legal reserves pumped into the member banks by the Fed, the banking system can, and does, acquire c. 208+ billion dollars in earning assets through credit creation (based on the money multiplier or expansion coefficient).

    The return of $208 billion dwarfs the interest foregone on idle reserves [sic]. I.e., the banks rate of return (payment of interest on bank balances) on required reserves = 1.4% & for excess reserves = .75%.

    The banks rate of return on more than $207 billion is obviously 207% higher. The conclusion is obvious. Legal reserves are not a tax, they are like manna from Heaven. I.e, the banks get paid twice.

    And unfortunately for the rest of us, this money creation does not provide the remotest assurance or possibility that the dollars created will be matched in the marketplace by an offsetting addition to the volume of goods and services offered.

    There are 3 taxes: (1) direct tax is the one on the citizens of the United States, and (2) the TAX, is INFLATION, (3) (and the last one, on the capacity of these collaborator’s minds).

    Legal reserves are a credit control device. The money supply can never be managed by any attempt to control the cost of credit.

  11. By flow5 on Oct 20, 2008 | Reply

    The crux of the cause of our monetary mismanagement, especially since 1965, is the assumption that the money supply can be managed through interest rates, specifically the federal funds rate, (or via the federal funds “bracket racket”, or thru a series of temporary “pegs”, or via a Taylor-like rule).

    We should have learned the falsity of that assumption in the Dec. 1941-Mar. 1951 period. That was what the Treas. – Fed. Res. Accord of Mar. 1951 was all about.

    The effect of tying open market policy to a fed Funds bracket is to supply additional (and excessive legal reserves) to the banking system when loan demand increases.

    The Fed’s technical staff either never learned, or forgot, how Roosevelt got his “2 percent war”. This was achieved by having the Fed stand ready to buy (or sell) all Treasury obligations at a price which would keep the interest rate on “T” bills below one percent, and long-term bonds around 2-2 1/2%, and all other obligations in between.

    This was achieved through totalitarian means, involving the control of total bank credit and the specific rationing of that credit. Plus there were controls on prices and wages that kept the reported rate of inflation down.

    There are only 3 interest rates that the Fed can directly control in the short-run; the discount rate charged to bank borrowers & the primary credit rate for both the PDCF & ABCP. The effect of Fed operations on all other interest rates is INDIRECT, and varies WIDELY over time, and in MAGNITUDE.

    As any monetarist knows, the money supply can never be controlled by any attempt to control the cost of credit.

    The only tool at the disposal of the monetary authorities in a free capitalistic system through which the volume of money can be controlled is free/gratis legal reserves.

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