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Fed seeks approval to pay interest to banks WSJ 5/7 The Fed is asking Congress for authority to pay interest on bank reserves, in an effort to gain better control over interest rates & more leverage to battle the credit crunch. Senior central-bank staffers broached the subject earlier this week with the congressional committees that oversee the Fed. Chairman Bernanke is expected to request the new authority in writing soon. The people familiar with the matter said key Democratic & Republican lawmakers probably would greet the request favorably, but warned quick passage of the measure isn’t guaranteed, given the political sensitivity of any steps that might aid banks. In 2006, Congress gave the Fed permission to pay interest on reserves - the sums banks keep on deposit at the Fed - but it delayed the effective date of the legislation until 2011 to postpone the cost to the Treasury. Banks are required by law to hold a certain fraction of their deposits in reserve accounts at the Fed, but receive no interest on these deposits. Having the authority to pay interest would solve 2 technical headaches for the Fed. If they earned interest from the Fed, banks would have no incentive to lend out excess reserves for less. That would make the Fed’s benchmark federal-funds rate, which banks charge on overnight loans to each other, less likely to plunge below the Fed’s official target - now 2% - on days when the banking system was awash in cash. The Fed could theoretically combat the credit crunch by buying securities or extending loans without limit without causing the federal-funds rate to fall to zero, something that could fuel inflation or distort markets. Paying interest on reserves would reduce the sum the Fed remits to the Treasury each year from earnings on the central bank’s portfolio of Treasury securities & loans. When the 2006 legislation passed, CBO estimated the move would cost the government $1.4b over 5 years. The Fed’s staff have suggested 2 ways Congress could proceed. It could let the Fed pay interest on all reserves, at a cost of about $150m a year, people briefed on the estimates said. Alternatively, the Fed could pay interest only on reserves in excess of banks’ required minimum. That would cost only $30m a year, which might make it more attractive to lawmakers. Either way, the Fed would have to keep the interest rate paid on reserves close to prevailing short-term market rates. In practice, the rate would probably be slightly below the federal-funds rate. The Fed would like Congress to act before its August break, to permit implementation by year-end, people familiar with the conversations said. The Fed manages interest rates by purchasing securities or making loans to banks & securities dealers. When the Fed buys Treasuries or makes loans directly to banks, it supplies financial institutions with cash; in effect, it prints money. The cash ends up as currency in circulation or in banks’ reserve accounts at the Fed. Since reserves earn no interest, banks lend out cash that exceeds their required minimum reserves, putting downward pressure on the federal-funds rate. To combat the credit crunch, the Fed has replaced half the roughly $800b of Treasuries it held last July with loans to banks & securities dealers. If the Fed used up all those Treasurys, it could purchase more, but in the process it would create large quantities of excess reserves. As banks lent out those excess reserves, the federal-funds rate would fall to zero. By paying interest on reserves, the Fed could put a floor under the funds rate & expand its balance sheet to deal with the credit crunch. The Fed has not cited that as the immediate objective of its request.