As Republicans in Congress sort out their giant tax cut and spending bill, one of the ideas floating around to save some money is to have the Federal Reserve stop paying interest.
For context, one thing the central bank does is act as a bank for banks. And like a commercial bank pays interest on its clients deposits, the Fed pays interest on banks’ reserves. Texas Republican Senator Ted Cruz has floated the idea of ending that practice and claims it could save $1.1 trillion over a decade.
The Federal Reserve pays interest to banks on their reserves for one big reason: “To move up or down interest rates in the economy,” said Seth Carpenter, Morgan Stanley’s global chief economist.
No bank in its right mind is going to make a loan to anybody for less interest than it’s getting from the Fed.
“It’s a question of at what rate banks have an incentive to lend money,” Carpenter said.
The Fed controls interest rates as best it can because that’s how it fights inflation and keeps people employed. So what would banks do if the Fed just stopped paying them interest?
“They would try to shift their short-term assets out of reserves and into other short-term things,” said Bill English, a professor of finance at Yale.
In other words? Banks would say: Get my money out of this zero-interest hellscape, let’s put it into something else, like Treasuries!
“And by doing so, they’d be bidding very aggressively at, say, auctions of Treasury bills. They’d be pushing down the interest rate on Treasury bills. Banks would pile into that asset until its return fell to something like zero,” English said.
So, like a school of piranhas, banks would pick interest rates down to the bone. That would keep rates for the rest of the economy far below what the Fed considers healthy. In reality, the Fed would not let that happen, English said.
It has other ways of paying interest to banks and other financial institutions, and it would have to use them to control rates.
“It wouldn’t even reduce the interest expense of the Federal Reserve,” said James Clouse, a fellow at the Andersen Institute for Finance and Economics.
The Fed doesn’t directly use tax revenue to pay interest, it uses profits from all the Treasuries and other investments it has. But maintaining control over interest rates would involve selling many of those investments
“So if you reduce the size of the balance sheet, you’re also reducing the net income of the Federal Reserve on average over time,” Clouse said.
That’s less profit to share with the government. So Clouse said ending interest payments on bank reserves wouldn’t end up saving much if any money at all, in the end.