The End of Reserve Requirements?

According to the Congressional Budget Office, as part of the bailout package the Fed will be allowed to pay interest on reserves banks keep at the Fed. The CBO says the Fed can start as soon as October 1, but since the bailout won't be signed into law until the end of this week at the earliest, interest payments won't be legal until after the 1st.

Congress had already approved payments, but the Fed couldn't start until 2011. In April, former WSJ reporter Greg Ip laid out why the Fed wants to pay interest:

by using open market purchases and sales of securities, the Fed adjusts the quantity of reserves banks hold and thus the interest rate they charge on excess reserves banks lend to each other (the federal funds rate). But since required reserves earn no interest, they are a tax, and like all taxes, create distortions. Over time banks minimized the portion of their deposit base subject to requirements and met a growing proportion of the remaining requirement through currency in their vaults rather than cash on deposit with the Fed. The Fed worried that
eventually required reserves would be so low it would have trouble implementing monetary policy. If banks earned interest on reserves, these problems would be mitigated.

The receipt of interest on reserves will reduce the incentive for depository institutions to economize on reserves. Depository institutions already avoid a considerable portion of the reserve-requirement "tax" through the use of sweep accounts. Consequently, ending or at least scaling back the present reserve requirement regime could have fairly small effects on total reserve balances at Federal Reserve banks. At the same time, significant cuts in reserve requirements would remove much of the incentive to incur wasteful resource costs required to maintain sweep arrangements.

"sweep" funds from transactions deposit accounts into savings accounts and thereby reduce required reserves of depository institutions....in 1994, balances in sweep accounts were slightly over $5 billion. Today sweep account balances exceed $760 billion, which amounts to more than 55 percent of the M1 measure of the U.S. money stock.