In a comment earlier today to this post, David Pearson shocked me by quoting the following passage from the Financial Services Regulatory Relief Act of 2006:
Balances maintained at a Federal Reserve bank by or on behalf of a depository institution may receive earnings to be paid by the Federal Reserve bank at least once each calendar quarter, at a rate or rates not to exceed the general level of short-term interest rates.
As I said to David Pearson in my reply to his comment, I am flabbergasted by this. The Fed is now paying 0.25% interest on reserve balances while and the interest rate on 3-month T-bills is now 0.01%. Yet the statute states in black letters that the rate that the Fed may pay on reserves is “not to exceed the general level of short-term interest rates.” In fact, as can be easily seen on the Treasury’s Daily Yield Curve webpage, only on rare occasions was the 3-month T-bill rate as high as 0.25% in 2009 and it has been consistently less than 0.20% for most of 2009 and all of 2010 and 2011. Perhaps the definition of short-term interest rates is more than 3-months, but the yield even on a one-year Treasury has been in the neighborhood of 0.1% for months and has been below 0.25% since April. So can anyone explain to me by what authority the Federal Reserve System continues to pay banks 0.25% interest on their reserve balances held at the Fed?
In looking around to see if anyone else has noticed that the Fed seems to be violating the very statute that authorizes it to pay interest on reserves, I found the following post from April 2010 by Stephen Williamson on his blog.
The Federal Reserve Act specifies that decisions about the interest rate on reserves are made by the Board of Governors, not by the FOMC. Obviously Congress did not think through the issue properly when it amended the Act. Since the interest rate on reserves is now the key policy rate, decisions about how to set it would appropriately reside with the FOMC. An interesting section of the Act is this one:
Balances maintained at a Federal Reserve bank by or on behalf of a depository institution may receive earnings to be paid by the Federal Reserve bank at least once each calendar quarter, at a rate or rates not to exceed the general level of short-term interest r ates.
This passage may be vague, but 1-month T-bills are now trading at 0.139% and the interest rate on reserves is 0.25%. The problem is that the Fed cannot do its job and (apparently) conform to the law. The T-bill rate has to be lower now, as the marginal liquidity value of a T-bill is higher than for reserves.
So Williamson also believes that the Fed lacks the statutory authority to pay as high an interest on reserves as it is now paying banks, except that he believes that the Fed would not be discharging its other statutory responsibilities properly if it followed the letter of the law on the rate of interest it may pay on bank reserves. But I admit to being totally unable to understand his reasoning. How can he conclude that the marginal liquidity yield of a T-bill is higher than the liquidity yield on reserves? Presumably in a competitive equilibrium, the pecuniary yield plus the liquidity yield on alternative assets must be equalized. But if banks can earn a higher rate on reserves than they can on T-bills, they hold only reserves and no T-bills. Non-banks, on the other hand, are ineligible to hold interest-bearing reserves with the Federal Reserve System, and must hold lower-yielding, less-liquid T-bills. So the rates on T-bills and reserves held at the Fed are not consistent with competitive equilibrium, and no inference about liquidity yields, premised on the existence of competitive equilibrium, follows from current yields on reserves and T-bills.