One frequently overlooked provision of the Bailout Act is that it gave the Federal Reserve permission to pay interest on bank reserves immediately, rather than in 2011. The Fed therefore announced last Monday, October 6, that it would begin doing so this past Thursday, October 9. Here is the Fed press release.

The long-run rationale for this change is to permit the Fed to hit its target Federal funds interest rate more reliably, and other central banks throughout the world have already implemented this reform. The short-run rationale is that troubled banks will now be earning interest on their reserve assets, which previously earned no interest.

But I am concerned that in the midst of a potential liquidity crisis, this change can have unintended negative consequences. I can think of four:

1. During a liquidity crisis, banks tend to increase their reserves and thereby decrease their lending to the general public. On top of reducing the flow of savings, this puts deflationary pressure on the money stock. Because banks now receive interest on reserves, they have an incentive to do more of this, accelerating the scramble for liquidity. Indeed, bank anticipation of this change may have been a factor in the tightening of U.S. credit markets last week, after passage of the Bailout Bill.

2. Any particular day, the interest rates on actual Federal funds loans between banks are distributed all round the Fed's target, above and below, with the average not even being on target sometimes. Paying interest on reserves eliminates the lower tail of this distribution, so now banks will no longer lend on the Federal funds market at any rate below what they receive on their reserves. This may be good for the flush banks lending reserves but possibly not so good for the cash-starved banks borrowing reserves, some of which will now end up paying a higher interest rate on the Federal funds market, or curtailing their own lending. Both of these results seem to be the opposite of what the Fed would want in this situation and again could have contributed to last week's credit tightening.

3. Paying interest in effect converts bank reserves into Treasury securities. Any interest the Fed pays will reduce the seigniorage it earns, which by itself is good. But since there is no overall change in total federal expenditures, the reduction in seigniorage also increases the government debt by an equivalent amount. The present value of future tax payments therefore undergoes a one-shot increase by the total amount of reserves receiving interest, which is now approaching $150 billion (not counting banks' vault cash, for which the Fed will not pay interest). If Ricardian equivalence holds, meaning investors correctly anticipate future tax liabilities, this increase could have been one factor helping to initiate last week's stock market decline.

4. Although paying interest on reserves leaves the entire size of the monetary base unchanged, it also at one fell swoop reduces how much of the base qualifies as true outside money that is an asset only, paying no interest. (This is the flip side of point 3.) And it is the supply and demand of outside money ALONE that anchors the price level. (A point that Don Patinkin taught economists years ago.) Of course, paying interest on reserves simultaneously reduces bank demand for outside money by an equal amount, so the immediate effect should be entirely neutral. But at a time when regulators are worried about deflation and a flight into outside money, does it seem wise to hit the economy with a sudden shock, reducing the quantity of outside money by 15 percent, even with a hopefully offsetting 15 percent fall in demand? Could this sudden fall in the quantity of outside money at a period when otherwise demand is rising have been another factor contributing to the events of last week? That is a very complicated question, and I don't pretend to know the answer.

If the current liquidity scramble warranted accelerating any future change, you would have thought that the Bailout would instead have permitted the Fed to eliminate all reserve requirements, something it can do beginning in 2011. Perhaps that might have appeared too much like deregulation at a politically inopportune moment. Perhaps the Fed is more interested in centrally planning interest rates. Or perhaps it felt such a change unnecessary since it can under current law eliminate reserve requirements on a temporary emergency basis.

Hat tip to my former student, Christian Warden, for calling this provision of the act to my attention.