Bernanke: Testimony not given by Ben Bernanke on Wednesday makes better sense than much of what the Federal Reserve chairman has delivered. He plans to raise the interest paid on the $1.1 trillion of bank reserves held at the Fed and use that rate as a new benchmark. That should succeed in tightening monetary policy without causing dangerous illiquidity.
When the snow-delayed House Financial Services Committee hearing does convene, members may appreciate that the interest rate the Fed pays on reserves would probably serve better as a benchmark than the federal funds rate, because the amounts involved are much larger.
The Fed had previously indicated that it would drain liquidity from the market through reverse repurchase agreements and asset sales — before lifting interest rates. That could have reduced the availability of credit without reducing demand, thereby creating an imbalance that could have starved important sectors of the economy of funding.
By raising the interest paid on reserves, the Fed would narrow the gap between short and long-term rates without withdrawing liquidity from the system. Bernanke also makes the plausible claim that these payments would not represent a Fed subsidy to banks, because money markets would adjust to reflect the rate the Fed was paying.
Another strand of Bernanke’s plan, turning some excess reserves into term deposits at the Fed, also makes sense both to fund the Fed's current massive balance sheet and to prevent their withdrawal to feed speculative activity in the financial system.
So far, so good. But Bernanke’s other trial balloon, floated in a footnote to his testimony, is problematic. He wants eventually to eliminate the reserve requirement currently imposed on banks, preferring to think reserves can be managed through the interest rate paid on them. But that seems alarmingly theoretical. And the Fed arguably could have countered the housing bubble by increasing reserve requirements as the Bank of Spain did — making monetary policy appropriately counter-cyclical.
The idea of abandoning reserve requirements gets a poor grade. But the part of Bernanke's plan that involves paying higher interest on bank reserves gets much better marks, at least in theory. Now to put it into practice.
