Interest on Reserve, new route for Fed?

Today Fed announced another $630 billion injection to market. The Fed's expansion of liquidity, the biggest since credit markets seized up last year will settle the funding markets down, and allow trust to slowly be restored between borrowers and lenders. On the other hand, the Fed's balance sheet is about to explode.

Under current procedures, any time the Fed has provided market liquidity by injecting reserves into the banking system, the increase in reserves has had to be ’sterilized’ by selling Treasuries, or conducting reverse repos. However, those means of sterilization threatened to run up against certain balance sheet constraints: The Fed now has less than $250 billion of Treasuries that it hasn’t lent out, and the Treasury’s overfunding could eventually bump up against the debt ceiling.

With interest on reserves, the Fed would not have to sterilize injections of reserves into the banking system. Normally, reserve injections need to be sterilized to prevent the fed funds rate from undershooting the FOMC’s funds rate target. With interest on reserves, wherever the Fed sets the rate on its deposit facility would effectively set a floor under the funds rate: anytime the effective funds rate would be below the deposit rate, banks would have an incentive to deposit excess reserves with the Fed. Excess reserves would be ’sterilized’ by banks depositing them with the Fed.

One proposed method would be like this: Fed set the deposit rate at the FOMC funds target rate and then inject massive amounts of reserves into the banking system — possibly by increasing TAF or similar facilities — and allowing the excess reserves to be deposited with the Fed at the target rate. Following such an operation, the Fed’s balance sheet would contain more risky assets and — on the liability side — more deposits and the monetary base would be roughly unchanged; the private sector’s balance sheet would contain less risky assets and more safe assets in the form of deposits with the Fed. The effect on the private sector balance sheet from the TARP is similar, though in that plan Treasury debt takes the place of Fed deposits.

This is regarded as an alternative route for Fed compared to direct bailout. Instead of buying bad assets in one step, Fed leaves himself a backdoor and increases its ability to expand its existing size of liquidity facility. But the key problem left here is how to determine the floor rate and how about the willingness of banks to deposit the money in Fed other than pursue other higher profitable investments?