By Michael S. Derby
NEW YORK (Reuters) -A Republican senator’s plan to take away the Federal Reserve’s power to pay banks interest on cash they park on central bank books could cause chaos for monetary policy implementation if it were implemented, market participants said.
In recent days, Senator Ted Cruz of Texas has been speaking about this power and his desire to see it ended as part of what he views as an effort to save money by the federal government. Stripping the Fed of the longstanding power would save the government $1 trillion, Cruz said in a CNBC interview last week. The senator said then that he did not know if it was likely his effort would work but that it was certainly possible.
On Wednesday, Bloomberg reported that Cruz had also lobbied President Donald Trump, who has long been at odds with the Fed, as well as Republican colleagues, about his idea. “We’re agonizing trying to find a $50 billion cut here and there. This is over a trillion dollars, big dollars in savings,” Cruz told Bloomberg, saying of the payments, “half of it is going to foreign banks, which makes no sense.”
Cruz’s office did not respond to a request for comment. The Fed declined to comment.
Cruz’s effort is being treated cautiously by Senator Tim Scott, the Republican from South Carolina who chairs the Senate Finance Committee. “While the desire to return to pre-crisis monetary policy operating procedures is understandable,” the matter must be considered under normal Senate procedures, Scott said in a statement. Any move on this must start with a hearing, Scott said, adding, “this is not a decision to be rushed – it must be carefully considered and openly debated.”
The Fed’s power to pay banks interest, granted by Congress, took effect in 2008 as the financial crisis dawned. It quickly gained prominence as part of a large-scale overhaul of the monetary policy architecture, as the Fed confronted the greatest economic downturn since the Great Depression.
As it now stands, the Fed pays deposit-taking banks 4.4% for reserves. It uses another tool called the reverse repo facility to take in cash from money market funds and others, paying them 4.25%. Together, the two rates are designed to keep the federal funds rate, the central bank’s main tool for influencing the economy, within the desired range.
Paying financial firms for de facto loans of cash is essential for interest rate control due to the very large amount of liquidity created by bond buying stimulus efforts. During the COVID-19 pandemic, the Fed more than doubled the size of its balance sheet to a peak of $9 trillion, with asset purchases providing support to the economy beyond what the then near-zero short-term rates could deliver.
If the Fed did not have the power to pay interest on deposits, the still substantial amount of liquidity sloshing around in markets would prevent it from controlling short-term rates. That said, concerns have long existed, even among some former central bankers, that paying banks money to deposit cash at the Fed is effectively a subsidy to banks.
The other issue with paying interest on reserves is that it has led the Fed into an unprecedented period of loss-making. The Fed has been operating in the red because the interest rate it now has in place outstrips the income it earns off bonds it owns. Most analysts expect the loss-making to occur for some time to come.
Fed losses mean that it is not handing over profits back to the Treasury, as it is required to do when it is in the green. Sums handed back to the Treasury over recent years contributed modestly to lowering deficits.
Experts believe Cruz’s plan would completely fail to achieve its goals and would instead cause huge upheaval in money markets.
Barclays Capital economists said on Tuesday that ending the power would simply push the cash into the reverse repo facility, which means the central bank would still be paying lots of interest to financial firms, thus negating any deficit savings. J.P. Morgan strategists said in a note last week that under Cruz’s plan, “the Fed’s ability to control money market rates may be compromised, complicating its efforts to guide broader financial conditions via the fed funds rate and other money market rates.”
(Reporting by Michael S. Derby in New York; Editing by Matthew Lewis)
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