New Fed Chief Gets Same Old Republican Pushback on Balance Sheet
(Bloomberg) -- Republican lawmakers made the Federal Reserve’s bloated balance sheet a big political issue for the last two heads of the U.S. central bank. During his first congressional testimony as Fed chairman, they hammered home to Jerome Powell that they were still on the case.
Jeb Hensarling, the Texas Republican who chairs the House Financial Services Committee, began the hearing Tuesday by declaring that “as we begin a new era in Federal Reserve leadership, I think it is a good time to re-establish congressional expectations.”
His criticism focused on an obscure tool used by the Fed to manage interest rates, which it will need to retain if it opts to maintain a big balance sheet. That will be a key decision for the Fed in coming years under Powell -- who appears before the Senate Banking Committee Thursday -- alongside its views on the benefits of emergency-era asset purchases should it face another severe economic downturn.
“This is a longstanding concern that Republican-wing conservatives have had, and it looks like they are going to be holding onto it,” said Peter Hooper, chief economist at Deutsche Bank Securities in New York. “Jay handled it pretty effectively. I don’t think he is going to sway on this one."
Powell’s predecessor, Janet Yellen, began shrinking the multi-trillion-dollar bond portfolio last year that her predecessor, Ben Bernanke, amassed to lower borrowing costs and support the economy after the financial crisis. Both took constant fire from Congress over the bond-buying program, which many Republicans viewed as an unprecedented and unwarranted expansion of the Fed’s footprint.
While the balance sheet has deflated a bit from its $4.5 trillion peak level, the Fed hasn’t committed to bringing it all the way back to its pre-crisis size. In fact, many at the central bank favor keeping it large, because they prefer the system of interest-rate management which the big balance sheet necessitated after the crisis.
Hensarling and other committee members used the interest payments the Fed makes on money borrowed from banks to fund its bond portfolio -- known as interest on excess reserves, or IOER -- as the focal point of their attack.
“It is critical that the Fed stays in their lane,” Hensarling said. “Interest on reserves, especially excess reserves, is not only fueling a much more improvisational monetary policy, but it has fueled a distortionary balance sheet that has clearly allowed the Fed into credit allocation policy, where it does not have business.”
The rate of interest Fed officials choose to pay on the central bank’s reserve liabilities, which banks hold as assets, has in the post-crisis period become their key tool for managing interest rates more broadly.
Many central bankers -- especially at the New York Fed, where monetary policy decisions get implemented via trading in the markets -- say IOER is an easier way to manage rates than the procedure they used before the crisis, when the balance sheet was relatively small. And it reduces systemic risk in the financial system, because more bank reserves on bank balance sheets reduces the extent to which banks need to borrow reserves from each other when they come up short of their requirements.
Shrink the balance sheet too much, and the ability to use IOER to set interest rates is weakened, while the financial stability benefits also go away. Right now, the Fed hasn’t made a decision about how much it wants to downsize, Powell said during his testimony on Tuesday. Practically, it doesn’t have to until the balance sheet is much smaller, a point which is still a few years away.
“I don’t expect to be returning to that decision in the near term,” Powell said. “I would just say that our current approach seems to be working very well,” he added, referring to the use of IOER.
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