Interest on Excess Reserves

It is being reported that some U.S. banks are warning that they might have to start charging a fee to depositors.  This would include individuals and companies.  In other words, if you have a checking account, you will likely have to pay a monthly maintenance fee.

The reason for this warning is due to fear (by the bankers) that the Fed may stop paying interest on excess reserves.  The minutes from the Fed’s October meeting suggest that this is an option that the Fed might take to offset the effects of “tapering”.

In other words, the Fed is going to slow down its monetary inflation at some point in the future.  It will keep creating money out of thin air, but just at a slower pace.  So to prevent the economy from being harmed too much (in the eyes of a statist), the Fed will eliminate interest payments on excess reserves.  I suppose the theory is that this would then encourage banks to reduce their excess reserves.  This would mean more fractional reserve banking and would likely lead to higher price inflation as money multiplies through the system.

Interestingly, in a true free market environment, people likely would pay a fee for banks to hold their deposits.  If you wanted to avoid such a fee, you would likely have to agree with the bank that the bank can lend out your money.  Otherwise, it is a loss for the bank.  Why would the bank hold your money for you while not being able to lend it out?  If you didn’t pay a maintenance fee, the bank would be losing money on its service.

Of course, in a true free market environment, the banks would not be getting bailed out and would not have the FDIC and the Fed as backstops.  Banks would have to take far less risk.

I would be surprised if the Fed decides to eliminate the .25% interest it pays on excess reserves.  This has been done since 2008 and it has helped keep a lid on prices by encouraging banks not to lend as much.

I’m guessing if the Fed reduced this interest, then it would just be eliminated.  It is already small, so I’m not sure what the point would be of reducing it to something like .10%.

If the interest payment is eliminated, I’m still not sure how much of a difference it will make.  As one person said in the article, it is not as if banks will suddenly start lending, because there isn’t the demand for it.  It may not be that the banks don’t want to lend.  It may be that people and businesses don’t want to borrow or simply can’t borrow due to their own financial situation.

If the Fed does eliminate the interest payments on bank reserves, then we will likely see the maintenance fees on checking accounts become more common.  Most Americans will complain about it.  In some sense, they are right to be mad because the big banks are continually being subsidized and bailed out at the expense of the little guy.

But Americans shouldn’t worry so much about paying a small monthly fee for their checking account.  They should worry about the massive price inflation that could be unleashed if banks start lending more.  Paying a $5 monthly fee to the bank will be nothing compared to paying an extra $25 or $50 a week for groceries.

In conclusion, I’m not sure why the Fed would threaten to reduce or eliminate interest payments on bank reserves.  The Fed has been able to more than quadruple the monetary base in the last 5 years with minimal consumer price inflation.  The Fed has been able to have its cake and eat it too.  Why would they risk changing this scenario right now?

If the Fed does eliminate interest payments and it has the desired effect of more bank lending, then we should all be fearful for the massive price inflation that will likely follow.