President's Message: Price Stability and the Payments System—Not-So-Strange Bedfellows
I've spent a good portion of my time as St. Louis Fed president touting the benefits of price stability, in particular the environment of low interest rates it engenders. More recently, as chair of the System's policy committee on financial services, I've been involved in one of the Federal Reserve's other major responsibilities: ensuring the integrity and efficiency of the nation's payments system.
In directing the committee's work—including monitoring new developments like smart cards, electronic cash and cyberbanking—I've come to realize yet another, seldom discussed benefit of price stability: It makes our payments system more efficient. How? It all has to do with interest rates and float.
Float is the interest earnings gained by one party or another while a payment is being processed. For example, checks and credit cards can earn float since funds remain in the purchaser's bank account, earning interest, until the payment is finalized, days or weeks later. The higher the interest rate, the more money you can earn. Cash and debit cards, on the other hand, earn no float; with these payment methods, the transaction is settled swiftly.
From a corporation's standpoint, delaying the final settlement of its many payments can generate substantially more interest for the company. Thus, in choosing among the various ways to pay for things, a corporation has an incentive to select a payment method that will maximize its float.
Why do we care? A comprehensive Fed study conducted a few years ago revealed a striking regularity: The most float-intensive types of payment are the most costly to produce and process. This fact reflects the long, complex and often labor-intensive processing that such payments go through. A check may undergo several rounds of handling and be shipped by several modes of transportation before it is returned to the firm or individual who wrote it.
Therefore, anything that induces payment originators to choose more direct and less float-intensive instruments will tend to reduce the costs of operating the payments system, ultimately allowing banks to lower fees and merchants to lower prices.
Many innovative and low-cost payment technologies are now available. What has slowed their adoption is the financial incentive firms and individuals have to capture float. A monetary policy that achieves price stability, thereby keeping interest rates low, would go along way toward making these incentives the right ones for society.
The Regional Economist offers insights on regional, national and international issues. Views expressed are not necessarily those of the St. Louis Fed or Federal Reserve System.