NEW YORK (Reuters) -Federal Reserve Chairman Jerome Powell said Wednesday any move to strip the central bank of its power to pay interest on reserves would be difficult and take a long time to implement. “If you were to want to go back to scarce reserves, it would be a long and bumpy and volatile […]
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Fed’s Powell cautions against ending Fed power to pay interest on reserves
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NEW YORK (Reuters) -Federal Reserve Chairman Jerome Powell said Wednesday any move to strip the central bank of its power to pay interest on reserves would be difficult and take a long time to implement.
“If you were to want to go back to scarce reserves, it would be a long and bumpy and volatile road,” Powell told a Senate committee during testimony. “I wouldn’t recommend that we undertake that road” and if it were done it “would not save any money.”
Powell, speaking before a Senate panel, was discussing a power the central bank implemented in 2008 that allows it to pay deposit-taking banks interest for cash they park on the central bank’s books. The power gained unexpected prominence in the financial crisis after the central bank slashed its interest rate target to near zero levels and began buying bonds in large amounts to provide additional stimulus to the economy.
That shift was a fundamental change in how the central bank implemented monetary policy. Prior to 2008 the Fed kept reserves in the system scarce and used regular interventions to keep the federal funds target rate in line. After 2008 reserve levels exploded due to bond buying and the Fed kept its target rate in line with its interest-paying powers.
The Fed’s interest on reserves tool, now set at 4.4%, binds the top end of the federal funds rate, while the reverse repo rate that pays money market funds and other eligible firms for de facto loans, now at 4.25%, puts a floor underneath the central bank’s target. The Fed’s current federal funds target rate range stands between 4.25% and 4.5%.
The challenge for the Fed is that while its system has managed short-term rates very well, it has led to the central bank losing money. A self-funded institution, the Fed now pays banks more to control rates than it earns from the bonds it owns. That’s ended a long-running situation where the Fed helped defray deficits when it handed back excess profits. The Fed is expected to take some time to return to profitability. The Fed has stated repeatedly that profits and losses at the Fed do not affect its ability to achieve its policy goals.
Sen. Ted Cruz has been pushing his Senate colleagues to end the power to pay banks reserves out of a belief that this change would be a big contributor to lowering deficits.
Speaking to Senators, Powell said when it comes to taking the interest on reserve power away, “there’s an illusion that it would save money. That is not the case.” Powell went on to say a financial system with substantial liquidity also helps banks have the money they need to lend.
Powell also said ending the power to pay interest on reserves would be difficult to do. “I think unwinding it is a policy choice which could be executed but it would take years to execute, and it would be challenging, and quite volatile.”
Speaking to reporters Tuesday, New York Fed President John Williams said the power is “an absolutely essential way for us to control interest rates and carry out the monetary policy we need…to achieve our maximum employment and price stability goals.”
A wide range of analysts believe taking away the power to pay reserves would be akin to sawing a leg off a table and expecting it to remain stable. Removing the power in the absence of other action, such a move would likely drive considerable sums of cash into the reverse repo facility which would mean the central bank would still face considerable interest-related costs. It would also upend the Fed’s ability to manage short-term rates.
Moreover, to return to a scarce reserves system akin to that in operation before the financial crisis would also likely mean the Fed would have to aggressively shed bonds it owns. Since 2022 the Fed has been slowly unwinding the massive size of its holdings by allowing set amounts of securities to mature and not be replaced and it has not sold securities outright.
A more aggressive attempt to unload bonds could stress markets and sales of bonds are uncharted territory that many observers believe would be very difficult for Wall Street to deal with as it deals with large increases in government borrowing. A more aggressive move to shed bonds would likely drive up long-term borrowing costs, experts warn.
(Reporting by Michael S. Derby; Editing by Chizu Nomiyama )