JPMorgan Warns: Eliminating Fed's Interest Payments Could Disrupt Banking Sector

JPMorgan strategists have issued a warning that a proposal to eliminate the Federal Reserve's interest payment mechanism to banks could lead to significant disruptions in the banking sector, financing markets, and U.S. monetary policy. The proposal, suggested by Texas Senator Ted Cruz, aims to reduce government spending by halting the Fed's practice of paying interest on reserves held by depository institutions. However, JPMorgan's analysts argue that this move could have unintended consequences, potentially destabilizing the financial system and complicating the Fed's ability to implement effective monetary policy.

The current mechanism, where the Fed pays interest on excess reserves, is a crucial tool for managing short-term interest rates and ensuring financial stability. By eliminating this practice, the Fed would lose a key lever for controlling the money supply and influencing economic conditions. This could lead to increased volatility in interest rates, making it more challenging for the central bank to achieve its dual mandate of maximum employment and stable prices.

JPMorgan's strategists point out that the proposal could disrupt the financing markets, as banks rely on the interest paid on reserves to manage their liquidity and funding costs. Without this income, banks might be forced to seek alternative sources of funding, which could increase borrowing costs for businesses and consumers. This, in turn, could slow down economic growth and investment, further complicating the Fed's efforts to stabilize the economy.

According to Teresa Ho and her team at JPMorgan, if the average reserve amount is 300 million dollars and the interest rate is 3.5%, eliminating the interest on reserve balances (IORB) over a decade could save the government approximately 100 million dollars. However, this potential savings comes with significant risks. The IORB mechanism, established during the global financial crisis nearly two decades ago, has become a core tool for the Fed to control short-term interest rates. Eliminating it could alter banks' liquidity management practices, leading to a surge of funds back into the money markets and squeezing out existing participants in the Treasury, repurchase agreement, and federal funds markets.

Ho and her team further warn that eliminating IORB could significantly impact banks' profitability and liquidity management strategies, lowering short-term interest rates and increasing the frequency of the Fed's standing tools. More critically, it could cause the Fed to lose control over money market interest rates. The team's report to clients on June 6th emphasized that this move would complicate the Fed's monetary policy operations, making it harder to guide the overall financial environment through the federal funds rate and other money market rates.

The proposal to eliminate IORB raises deeper discussions about whether the Fed should revert to its pre-crisis policy framework. This framework involved setting the central bank's minimum lending rate to financial institutions and implementing monetary policy through daily operations in the bank reserve market. Eliminating IORB could push the Fed back to this "interest rate corridor" system and potentially shrink its balance sheet. However, JPMorgan strategists believe this scenario is unlikely, as it would lead to more Treasury securities being held by "non-Fed holders," increasing the overall term premium in the Treasury market.

In essence, eliminating IORB could jeopardize the Fed's control over money market interest rates, complicating its monetary policy operations through the federal funds rate and other money market rates. In conditions of abundant or excess system reserves, IORB and the overnight reverse repurchase agreement (ON RRP) are essential tools for managing liquidity. The strategists conclude that while the proposal to eliminate the Fed's interest payment mechanism might seem like a simple way to reduce government spending, the potential risks and unintended consequences are substantial. Maintaining the current system is crucial for ensuring financial stability and effective monetary policy.