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The Atomic Bomb that is About to Explode at the Federal Reserve

• Economic Policy Journal
I have consistently contended that Federal Reserve chairman Ben Bernanke is something akin to a mad scientist who, in his development of new "tools" to manage monetary policy, is probably unaware of all the nuances and ramifications of the new tools he is developing. Indeed, one problem with one of his new tools may be about to blow up in his face.

It turns out that Bernanke's decision to pay interest on reserves held at the Fed by member banks has some twists to it that make what he is doing likely illegal. The blog Uneasy Money points this out in a post titled, Is the Federal Reserve Breaking the Law:



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.
Got that? The Fed, as I have pointed out a number of times, is paying interest to bankers many times what is available in the marketplace and this turns out to be illegal.

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