Along with the FRB’s seemingly-epochal decision to raise rates by 25 basis points comes criticism yet again of the rates paid by the central bank in interest on excess reserves (IOER) and in the reverse-repo program (RRP). It won’t take much time before attention again turns to how much these payments mean to big financial-services firms – indeed the Wall Street Journal aimed missiles straight at IOER earlier today. After all, why should the FRB pay big financial-services institutions? Arguably, big banks should pay the central bank for the privilege of doing business with it, thus giving the FRB still more billions to send Treasury’s way. But, as a new paper FedFin will issue next week makes clear, what might at first appear to be an FRB subsidy to financial behemoths is a critical tool the FRB has to have as long as rates are low, growth is halting, and post-crisis rules make it hard for banks to turn deposits into productive assets. IOER is a clear example of the complex trade-offs that have to be crafted as long as the Federal Reserve is trying to have its cake – a handle on short-term interest rates – and eat it too through a lot of very tough and costly rules.
Some who might otherwise worry about monetary policy without IOER are prone to throwing caution to the winds when they contemplate how much federal spending might be funded if only taxpayers took IOER back from the big banks they don’t much like anyway. But, easy solutions to IOER are as hard to find as easy answers to making the economy grow and the financial system resilient.
In our new paper, we lay out the reasons why the FRB has been forced to rely so much on IOER and why banks park so much money – $2 trillion at last count – in excess reserves. Some have suggested that paying banks interest on these huge sums gives the central bank the tools with which to hold its huge portfolio – now clocking in at $4.2 trillion. I’ve been sharply critical of this portfolio because of its adverse impact on market valuations and thus on wealth distribution. The issues of the portfolio and IOER are, though, totally distinct – as our new paper will detail, the Federal Reserve “pays” for the assets it bought from banks by hiking bank reserve accounts.
The Fed’s goal was, though, to give banks the fuel with which to light economic fire. Banks didn’t take these reserve bonanzas into the economy because economic malaise meant low loan demand, new rules make new loans costly, and hard-learned scruples about taking credit risk discouraged many banks from trying to lead the U.S. out of the post-crisis recession.
Importantly, some of the biggest banks with the largest reserve accounts are custody banks. They not only sold assets to the Fed, but thereafter also became awash with deposits as their asset-management clients needed places to park cash in order to ensure MMF and mutual fund liquidity under stress. A good thing too, as regulators rightly concede, but custody banks are supposed to house these deposits only in no-risk assets. With shortages of Treasury securities and given sometimes-frightening fixed-income market volatility, excess reserves are the most prudent place to put all these billions. Unfortunately, the supplementary leverage ratio penalizes custody banks for doing so – one reason excess-reserve balances are down at the Fed and another source of systemic risk as asset-management money goes sloshing around the world looking for a new home.
Assume, though, one were able to discount all of the reasons banks now house funds at the Fed to demand that the central bank cease IOER. If it still maintained the RRP as some suggest, there might – might – be a floor on short-term rates, but at least $2 trillion of assets would flood out of excess reserves into the financial system. A bit of these unleashed funds might end up in prudent loan opportunities banks somehow overlooked due to IOER, but the vast majority of it would head into the fixed-income market in ways no one now can forecast.
Because the Fed’s ability to ensure a short-term rate floor would be dramatically undermined, if not altogether obliterated without IOER, the central bank might well be forced to sell some of its own assets in a desperate attempt to govern interest rates. No one can forecast how still more trillions of assets set loose would fare, but it’s clear that, at the very least, market volatility would spike and financial stability would be endangered.
Regardless of any uncertainty about systemic risk from tumultuous asset sales, it’s clear that, in a rising-rate environment, the Federal Reserve would take a big loss on the securities it would be forced to sell in such a scenario. This compounds the challenges for anyone hoping to use IOER to make a quick billion or more to fund federal spending. Sure, ending IOER would take money the Fed now sends to banks so funds could instead flow to Treasury, but the Fed might well incur so large a loss selling securities to make up for IOER’s rate-setting power to create a loss to the Treasury as a result of these asset sales.
Reducing the portfolio over time through, for example, allowing it to run off, normalizes markets; forced sales such as those required if IOER is summarily eliminated endanger them. Because of this, the Congressional Budget Office would likely consider an end to IOER having at best a neutral fiscal effect; more likely, it would call this a taxpayer loss, confounding those who would endanger the economy in hopes of penalizing big banks or in search of some new funds to spend.