How Monetary Policy Suddenly Became Controversial

(Bloomberg Businessweek) -- Last year the Federal Reserve paid about $26 billion in interest on the money banks kept deposited there, up from the zero dollars it paid before the financial crisis a decade ago. For many people, this is a source of distress. The more the Fed pays in interest to banks, the lower its profit, the less it pays into the Treasury, and the more taxpayers have to pick up the slack. It seems like a boondoggle, but the Fed regards its payments as a routine instrument of monetary policy, no more political than steering a supertanker.

The reserves at issue consist of the cash banks keep in vaults, plus electronic money that they stash at the Fed itself. Before the crisis, banks that were short of their minimum level of reserves would have to borrow reserves from other banks at what’s known as the federal funds rate. The Fed can shrink the amount of reserves in the banking system by selling bonds because banks use reserves to buy them. The scarcer the Fed made reserves, the higher the federal funds rate would climb. 

That system worked well for decades—pre-crisis, banks would never hold on to more than their minimum reserves because they earned no interest. But it fell apart when the Fed started buying trillions of dollars in Treasury and mortgage bonds from banks and their customers in a bid to stop the economy’s slide, paying for them by crediting the banks with more reserves. The Fed’s objective in scarfing up bonds was to drive their prices higher, causing their yields to fall, in hopes that lowering long-term interest rates would encourage more spending and investment. But a side effect was to give banks far more reserves than they would ever need. 

Since the Fed could no longer keep a floor under short-term interest rates by making reserves scarce, it started paying interest on reserves instead. In 2008, with the financial crisis deepening, Congress gave the Fed permission to pay interest to banks on all of their reserves—both the (small) required amount and the (now huge) excess amount, i.e., the amount banks keep at the Fed voluntarily. Since any bank can earn interest risk-free by depositing money at the Fed, it would be brainless to lend money to anyone else for a lower rate. (In practice, rates tend to average slightly lower because some financial institutions aren’t eligible to deposit at the Fed, but for the most part the policy holds.)

The Fed’s interest payments didn’t arouse concern when they began in 2008 because interest rates were extremely low, meaning the payouts were tiny. Once the Fed started raising rates at the end of 2015, critics took to the internet to rage about what they considered an outrageous heist. “Guns and ski masks are so passé. It [sic] just so much easier to type in the transfer and paper it over with some legal mumbo-jumbo,” wrote one commenter on the Wolf Street finance website in 2016. Another was more succinct:  “HEADS … ON … PIKES.”

Members of the House Financial Services committee grilled former Fed Chair Janet Yellen at a 2016 hearing. “Please, please explain,” Representative Maxine Waters of California, the committee’s ranking Democrat, pleaded. Jeb Hensarling, the Texas Republican who chairs the committee, told Yellen she was using the interest-paying authority in a way Congress never intended. He said he lets his 12-year-old son use a Louisville Slugger for batting practice, but “it doesn’t mean I approve it for chasing his sister around the house.”

Payments to banks have risen further since then. This January the Federal Reserve System announced it spent $25.9 billion in interest last year, “primarily associated with reserve balances held by depository institutions.” Deutsche Bank estimates that the payments will rise to about $39 billion this year. In June the Fed raised the top of the federal funds rate range to 2 percent and the interest rate on reserves to just below that: 1.95 percent.

In an interview this year, Representative Andy Barr, a Kentucky Republican, said the payments to banks resemble U.S. Department of Agriculture payments to farmers not to grow crops. “That is distortionary,” says Barr, who chairs the House Financial Services subcommittee on monetary policy and trade, which has jurisdiction over the Federal Reserve. “I’m arguing that it diverts resources away from the American people into a very unproductive place, and that is parked at the Federal Reserve.”

The problem with Barr’s argument is that the 1.95 percent banks earn on their reserves is still well below what they charge on mortgages, car loans, student loans, small business loans, and the like. So if they see a good opportunity to make one of those loans, the amount they’re earning on their deposits at the Fed won’t be enough to discourage them. Nor is it clear that banks are taking advantage. The amount of interest the Fed pays to banks is dwarfed by the amount of interest the central bank continues to earn on the bonds it acquired for its portfolio. Last year that amount was $114 billion. The Fed pays the Treasury all the profits it makes after paying for expenses such as salaries, heat, and light, which added $80 billion to the nation’s coffers in 2017. 

Don’t expect this issue to go away, though. Suspicion of central banks is as old as the republic. President Andrew Jackson, who crusaded to kill the Second Bank of the United States in 1833, once said, “The Bank is trying to kill me, Sir, but I shall kill it!” 

To contact the editor responsible for this story: Jillian Goodman at jgoodman74@bloomberg.net

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