Whenever a government agency gains a new power, there’s a risk that, whatever the power’s original intent, it will end up being put to other uses, perhaps good, but often bad.
Such is the case for the Fed’s power to pay banks interest on their Federal Reserve deposits. That power was originally awarded to the Fed in 2006 to allow it, starting in October 2011, to reduce banks’ cost of meeting statutory reserve requirements. During the financial crisis the implementation date was moved forward to October 2008, the Fed’s hope at the time having been that a positive interest rate on excess reserves (IOER) would establish a new, above zero “floor” for the effective federal funds rate. However, as I explained in a recent post, because subsequent Fed reserve creation left the banking system flush with reserves, banks had no need to borrow federal funds unless they could profit from the difference between the borrowing rate and the IOER. Consequently, the interest rate on reserves, instead of serving as an effective funds rate floor, ended up becoming a ceiling.
Since the economy began recovering from the crisis, the Fed has relied exclusively on IOER to keep the trillions of dollars in fresh reserves it created during and since the crisis from fueling inflation: by raising the IOER enough, it can always encourage banks to continue sitting on those reserves despite improved lending opportunities: the proportion of excess reserves and other bank assets depends, at least in part, on the relative yields of these alternatives. A higher rate of IOER thus serves as a substitute, when it comes to reining in lending, spending, and inflation, for reducing the total available quantity of bank reserves, as the Fed might do by selling-off some of the assets it acquired in the course of three massive rounds of Quantitative Easing.
So, the good news is that the Fed has gained a new tool for controlling inflation. The bad news is that, unless Congress does something to stop it, the Fed could well end up abusing this new tool to help a fiscally-challenged Trump administration (or any later administration, for that matter) paper-over its deficits.
For revenue-hungry governments to get central banks to fund their debts is itself nothing new, of course. The first central banks were set up with little else in mind. And if modern central banks are no longer slaves to national treasuries, they’re still under constant pressure to cater to them — pressure to which they often give in.
The Fed is hardly an exception. Although nominally independent, it set aside its mandate to keep prices stable to help finance two world wars. Then, when Fed Chairman Thomas McCabe tried to limit the Fed’s involvement in financing the Korean War, Truman sacked him. Inflation wasn’t a problem during the Eisenhower years; but it might have been had Eisenhower himself not been both a proponent of balanced budgets and an inflation hawk. When Eisenhower’s less fiscally conservative successors again pressured the Fed for support, the eventual result was double-digit inflation. And when the Carter and Reagan administrations at last allowed Paul Volcker to reel inflation in, they did so only because it had become such a scourge that no one thought it prudent to stop him.
Fear of inflation has kept a lid on the Fed’s financing of deficits ever since. But thanks to interest on reserves, it may not do so any longer. Now, if the Fed decides to gobble-up still more Treasury or government-agency securities, putting a like sum of fresh reserves at banks’ disposal, it can still keep inflation at bay by hiking the IOER enough to bribe banks to hoard the reserves instead of lending them out.* As I’ve noted, the Fed has already been using this strategy to keep the banks from shedding the trillions of dollars in excess reserves they accumulated as a result of three massive post-crisis rounds of Quantitative Easing.
For the Fed to monetize deficits during a recession is one thing; in principle, at least, it can hasten recovery by making up for slack private demand for funds. But at other times it’s likely to do harm, whether it leads to inflation or not. By buying government (or agency) debt, and paying banks to hoard the reserves it creates by doing so, the Fed shunts a bigger share of the public’s savings into the Fed’s coffers, and from there to government or its agents. As more savings are sent the government’s way, fewer are left for private investment, including bank loans to small businesses. The Fed’s tendency to favor Treasury and agency securities when conducting monetary policy operations, though innocuous enough when banks hold only minimal excess reserves so that the Fed leaves only a relatively modest “footprint” on overall credit allocation, becomes a serious matter when banks pile-on excess reserves, turning the Fed into the central-bank equivalent of the abominable snowman.
Inflationary finance has similar consequences. But while inflation makes headlines, reserve hoarding doesn’t. That’s why the Brave New World of interest on reserves is so dangerous. Faced with the usual pressure to help the government pay its bills, Fed officials, and a pliant or weak Fed Chair especially, might cave-in to the government’s demands while still meeting the Fed’s inflation targets. In theory they could go on meeting the governments’ demands until every penny in bank deposits is financing some government spending, leaving nothing for private-sector borrowers.
A farfetched possibility? Maybe not. President Trump is likely to appoint a new Fed Chair in 2018, if not before. He’s also likely to fill two vacant slots on the Federal Reserve Board. Will those appointees be willing to tell a deficit-challenged Trump administration to go fly a kite? They might: but it wouldn’t be wise to count on it.
And if Trump sticks to his campaign promises, his administration may very well end up swimming in red ink: according to reputable estimates, if carried out, Trump’s spending and tax plans, including his plans for infrastructure spending and wall-building, and his promise to retain some of the most expensive parts of Obamacare, will boost government borrowing by roughly a third within a decade, and could double it by 2036.
Congress shouldn’t risk having the Fed once again become a mere pawn to Treasury. Fortunately, the anticipated reform of the Dodd-Frank Act will provide it with a perfect opportunity to take necessary action. The fix is straightforward: amend the law to allow interest payments on banks’ legally required reserves only, but not on their voluntarily-held excess reserves. If the Fed needs to tighten credit to avoid inflation, it can do it the old-fashioned way, by selling-off securities. (The reasons Fed officials have been offering for not selling off at least some of those securities are, by the way, mostly hogwash.) If the Fed is worried about booking losses, Congress should offer to indemnify it. That’s a small price to pay to keep our monetary system from becoming one big government piggy bank.
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*Kindly spare me the tedious observation that banks don’t “lend out” reserves. As I’ve explained more than once in this forum, this expression is merely economists’ shorthand, serving to describe the process that begins with banks crediting borrowers’ accounts with lent sums, is followed by the borrowers’ drawing on their borrowed deposit credits by writing checks or otherwise transferring funds to various payees, and finally, other things equal, by a transfer of reserves from the lending bank to the payees’ banks, for the sake of settling inter-bank dues. The outcome of it all is, so far as the lending bank is concerned, much the same as it might be were it to simply hand reserves, in shape of so many stacks of fresh Federal Reserve notes, to those who borrow from it.
