No, I don’t mean sections 8 and 10 of the Constitution’s first article — though goodness knows a case can be made (and has been made recently, and most eloquently, by CMFA Adjunct Scholar Dick Timberlake), that it hasn’t adhered to the letter of that law, either. I’m referring to the law authorizing the Fed to pay interest on depository institutions’ reserve balances, or IOR, for short.
You see, according to Title II of the 2006 “Financial Services Regulatory Relief Act” — that law that originally granted the Fed authority, commencing October 1, 2011, to begin paying IOR — the Fed is allowed to pay interest, not at any old rate it chooses, but “at a rate or rates not to exceed the general level of short-term interest rates.”
As the name of the 2006 Act suggests, its purpose was to relieve financial institutions of unnecessary regulatory burdens. The fact that depository institutions’ reserve balances at the Fed, including minimum balances they were required to hold, bore no interest, had long been regarded as one such unnecessary burden. So long as reserve balances paid no interest, reserve requirements amounted to a distortionary tax on bank deposits subject to them. In the words of then Fed Governor Donald Kohn, who testified in favor of IOR back in 2004, the payment of interest on reserves, and on required reserves especially, would result in improvements in efficiency that “should eventually be passed through to bank borrowers and depositors.”
Since the original intent of IOR was to remove an implicit tax on deposits, and not to have the Fed subsidize those deposits, it’s easy to understand the law’s insistence that the Fed pay IOR only at “a rate or rates not to exceed the general level of short-term interest rates.” It also easy to see why most economists, including the Fed’s own experts, treat the federal funds rate as an appropriate proxy for the opportunity cost of reserve holding, and hence as one of the short-term rates that the rate of interest on bank reserves ought “not to exceed.” Indeed, because overnight lending involves some risk and transactions costs, while banks would earn IOR effortlessly and without bearing any risk, the IOR rate should logically be strictly below, rather than below or equal to, the federal funds rate.
Fast forward to 2008. Among its other provisions, the “Emergency Economic Stabilization Act” passed on October 3rd of that year “accelerated” the Fed’s authority to pay interest on bank reserves, making that authority effective as of the new law’s passage, instead of as of October 1 of 2011. Significantly, the 2008 measure did not otherwise alter the language of the original legislation. The rush to implement IOR was, nevertheless, based on motives quite different from those that informed the 2006 Act. As then-Chairman Ben Bernanke explained, in an October 7th, 2008 speech he gave at the annual meeting of the National Association for Business Economics, in the wake of Lehman’s failure, the extent of the Fed’s emergency lending
had begun to run ahead of our ability to absorb excess reserves* held by the banking system, leading the effective funds rate, on many days, to fall below the target set by the Federal Open Market Committee. This problem has largely been addressed by a provision of the legislation the Congress passed last week, which gives the Federal Reserve the authority to pay interest on balances that depository institutions hold in their accounts at the Federal Reserve Banks. The Federal Reserve announced yesterday that it will pay interest on required reserve balances at 10 basis points below the target federal funds rate, and pay interest on excess reserves, initially at 75 basis points below the target. Paying interest on reserves should allow us to better control the federal funds rate, as banks are unlikely to lend overnight balances at a rate lower than they can receive from the Fed; thus, the payment of interest on reserves should set a floor for the funds rate over the day (my emphasis).
Thus, although the Fed was now chiefly concerned, not with relieving banks of an implicit tax, but with reinforcing its ability to hit its federal funds target, its plan was to do so in a manner that nevertheless complied with the letter, if not the spirit, of the 2006 law, by having IOR serve as a new, non-zero lower bound to the federal funds rate.
Alas, things didn’t work out quite as Bernanke and other Fed officials intended. Instead, the “floor” they’d laid out so carefully turned out to be rotten, chiefly owing to the fact, although they keep balances with the Fed, Fannie and Freddie and other GSEs aren’t eligible for IOR.Consequently, their involvement created an arbitrage opportunity that Fed officials hadn’t anticipated, with banks borrowing funds from GSEs overnight at rates sufficiently below the IOR rate to turn the banks a tidy (if modest) profit.
The crux of the matter is that the effective federal funds rate — that is, the rate that was actually being paid for overnight funds — quickly ended up falling below the IOR “floor” and, therefore, below the Fed’s target rate. In fact, as the red plot in the figure below shows, since December 2008, when the Fed set the IOR rate for both required and excess reserves at 25 basis points, the rate has always exceeded the effective federal funds rate, besting it on occasion by as much as 19 basis points.
Faced by this reality, the Fed made the best of a bad job by declaring (1) that instead of setting a fed funds rate target it would henceforth set a target “range;” and (2) that the rate of IOR was to define, not the lower bound (or “floor”) of the new target range, but the upper bound.
Man, I bet the Board of Governors makes some mean lemonade!
But while the Fed may have succeeded in saving face, it doesn’t follow that it managed to do so while still obeying the law. For converting the IOR rate from a floor to a ceiling meant setting it above rather than at or below “the general level of short-term interest rates,” taking that “general level” to be appropriately represented by the effective federal funds rate. Nor does letting the three-month T‑bill rate proxy the “general level” of (risk-free) short term rates — a reasonable alternative — get the Fed out of hot water, since that rate (the green plot in the figure) has generally been even lower than the effective federal funds rate:
The situation hasn’t gone unnoticed by Congress. Bill Huizenga (R‑Michigan), Chairman of the Financial Services Committee’s Subcommittee on Monetary Policy and Trade, drew attention to the matter following Janet Yellen’s June 22, 2016, Humphrey-Hawkins Testimony:
HUIZENGA: Thank you, Mr. Chairman, and back here, Chair Yellen.
So, in response to the financial crisis, the Emergency Economic Stabilization Act accelerated its authority that had been granted to start paying interest on reserves from 2011 back to October 1 of 2008. And according to the New York District Bank, the Fed expected to set interest on reserves well below the Fed’s target policy rate, that is, the federal funds rate. Had the Fed created such a, quote, “rate floor,” it would have complied with the letter of the law.
Section 201 of the Financial Services Regulatory Relief Act of 2006 explicitly states that interest on reserves can, quote, “not exceed the general level of short-term interest rates.” However, as we learned in last month’s Monetary Policy and Trade Subcommittee hearing, interest on reserves is above the Fed funds rate.
This above-market rate not only appears to have gone outside the bounds of the authorizing statute, it may also be discouraging a more free flow of credit in an economy that can and should be flourishing. …
As if taking this as his cue, Jeb Hensarling (R‑Texas), Chairman of the House Financial Services Committee, and one those responsible for introducing the 2006 legislation, grilled Yellen remorselessly on the subject:
HENSARLING: And as I think you know, Section 201 of the Financial Services Regulatory Relief Act says that payments on reserves, quote, “cannot exceed the general level of short-term interest rates.” Today, you are paying 50 basis points on interest on excess reserves. The fed funds rate yesterday, I believe, is 38 basis points. Is that correct?
YELLEN: Probably correct.
HENSARLING: So, you’re paying about — back to the (inaudible) calculation — a 35 percent premium on excess reserves. You’re paying a premium to some of the largest banks in America, is that correct?
YELLEN: Well, I consider a 12 basis point difference to be really quite small and in line with the general level of interest rates.
HENSARLING: OK. So, you believe you have the legal authority to do this, otherwise you wouldn’t do it, is that correct?
YELLEN: Well, I do believe we have the legal authority to do it…
HENSARLING: Madam Chair, would it be legal…
YELLEN: Our (ph)…
HENSARLING: Would it be legal for you to pay a 50 percent premium? You’re paying a 35 percent premium today. Would it be legal to pay 100 percent premium?
YELLEN: I believe it’s a small difference. And interest on excess reserves did not succeed as expected in setting a firm floor…
HENSARLING: And would it be legal…
YELLEN: … on the (inaudible) short-term interest rates…
HENSARLING: Would it be legal under the statute — would it be legal under the statute for you to pay twice the Fed’s fund rate as a premium on interest on reserves?
YELLEN: Well, I believe that the way we are setting it is legal and consistent with the act.
HENSARLING: No, I know. But that’s not my question.
YELLEN: It is — it is…
HENSARLING: What is the legal limit? What is the legal limit on which you can pay? What does the phrase exceed the general level of short-term interest mean? You’re saying that 12 basis points does not trigger the statute. At what point is the statute triggered?
YELLEN: It depends on exactly what short-term interest rate you’re looking at. There are a whole variety of different rates and…
HENSARLING: OK. Do you have an opinion on whether…
YELLEN: … whatever…
HENSARLING: … or not it would be legal to pay 100 percent premium?
YELLEN: Whatever level we set, the interest on reserves…
HENSARLING: Madam Chair, please, it’s a simple question.
YELLEN: … at, it funds (ph) going to trade below that level.
HENSARLING: Madam Chair, please, it’s a simple question.
YELLEN: It funds going to — to trade below that level.
HENSARLING: Madam Chair, please. It’s a simple question. Would it be legal under the statute to pay a 100 percent premium? If you don’t know the answer to the question, you don’t know the answer to the question.
YELLEN: Well, my interpretation is that it is legal.
HENSARLING: It would be legal to pay twice the market rate? That would not exceed the general level of short-term interest?
YELLEN: There is likely to be for quite some time a small number of basis points gap…
HENSARLING: Well, I…
YELLEN: … between interest on reserves and the Fed funds rate, and that is something that…
HENSARLING: I would simply advise discussing that with the legal counsel, because I think that, frankly, it (inaudible) common sense.
I’m going to go out on a limb and guess that Hensarling’s last “inaudible” word was “defies.”
Whatever the word was, it sure seems to me that, no matter how one slices it, an IOR rate “a small number of basis points” above the fed funds rate is one that “exceeds” that rate. But I’m not a Federal Reserve lawyer, so what do I know? Still, I wish someone deeply committed to making sure that financial institutions don’t get away with any hanky-panky (the CFPB, perhaps?) would go ahead and sue the Fed, so that Representative Hensarling and I can find out once and for all just what “not to exceed” really means.
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*That is, it’s ability to “sterilize” its emergency loans by disposing of Treasury securities.
