WASHINGTON — House Republicans are ramping up their criticism of the Federal Reserve for making interest payments to member banks on excess reserves, and may have identified a way to counter the central bank’s longstanding claim that the payments are critical to executing monetary policy.
The issue is to be debated Thursday at a Financial Services Committee hearing. Last week, Chairman Jeb Hensarling told Fed Chair Janet Yellen that interest on excess reserves, or IOER, should "not become a permanent tool of monetary policy."
"Normalization would suggest, after setting the level of reserves, short-term interest rates be set by market forces, but today they are set from the top down by an administered rate paid on excess reserves, which again, is a premium rate resting on uncertain legal authority,” the Texas Republican said.
Rep. Andy Barr, R-Ky., who chairs the panel's monetary policy subcommittee, went further, likening IOER to the bygone, Depression-era practice of stabilizing commodity process by paying farmers not to grow crops.
"The Federal Reserve, by paying interest on excess reserves, is effectively paying banks not to lend,” Barr said. “By guaranteeing the largest banks in America this low-risk, above-market rate of return on deposits, the Fed is discouraging lending into the real economy, effectively taking money out of communities across America and leaving less capital for Main Street households and businesses to prosper.”
Yellen defended the practice during her testimony, saying the portrayal of IOER as a big-bank giveaway is misleading and again arguing that the Fed uses it as a means of implementing the Federal Open Market Committee’s monetary policy decisions.
“We are reliant on IOER as our key tool for setting the federal funds rate, so that is a key instrument of monetary policy,” Yellen said.
But the hearing Thursday is designed to help Republicans flesh out alternatives. George Selgin, a senior fellow and director of the Center for Monetary and Financial Alternatives at the Cato Institute, said in his prepared testimony that the Fed should embark on an aggressive program to lower the IOER rate while simultaneously reducing its balance sheet. That would reinvigorate the market for funds that existed before the crisis and effectively make the IOER rate a lower bound of the Fed’s monetary operations, ensuring that whatever the Fed pays in IOER is a below-market cost of funds.
“The only difference between the new arrangement and the Fed’s actual, pre-crisis system will be that in the new one, the IOER rate will serve as an above-zero fed funds rate lower bound, as well as a means for compensating banks for holding required reserves and clearing balances,” Selgin said. “IOER will, in other words, serve only the purposes it was meant to serve … instead of serving purposes far removed from what those responsible for that legislation had intended.”
Yet banks are wary of forcing the Fed to make any change to the policy. Wayne Abernathy, executive vice president of regulation at the American Bankers Association, said Congress’ enhanced scrutiny of IOER — scrutiny that has at times been bipartisan — corresponds with a heightened risk of bad policies with unintended consequences.
“There’s always the perpetual concern that when policymakers are looking at an important issue and their understanding of it is incomplete or inaccurate, that bad policies will follow,” Abernathy said. “That’s our concern.”
But Norbert Michel, director of the Center for Data Analysis at the Heritage Foundation, said the ongoing practice of managing monetary policy without regard to the Fed’s inflated balance sheet is problematic and should be a top priority for Congress going forward.
“The whole implementation of it was a [disaster],” Michel said. “What they have right now is monetary policy divorced from the balance sheet, and that should be stopped.”
Almost from the Fed’s establishment, member banks have complained that the lack of an interest payment on required reserves amounted to a tax — it effectively prevented banks from making a return on assets that would otherwise earn a return. As a result, banks kept as little in reserve as legally possible, and used various technical accounting tricks to do so.
Congress ultimately agreed to allow the Fed to pay an interest rate on both required and excess reserves in 2006, with the expectation that the practice would be phased in starting in 2011. But the financial crisis in 2008 compelled that deadline to be sped up, and Congress authorized the Fed to begin paying IOER on Oct. 1 of that year.
Before 2008, the Fed implemented its monetary policy through what are called open market operations — essentially manipulating the money supply by buying and selling Treasuries. But the crisis dried up unsecured interbank lending, diminishing the Fed’s ability to set interest rates. The central bank instead moved to what is known as a “floor” system, whereby IOER takes the place of the money supply as the central mechanism of interest rate setting.
Donald Kohn, a senior fellow at the Brookings Institution and former vice chairman of the Fed, said the central bank’s ability to implement accommodative monetary policy in the crisis without being tethered to its actual supply of Treasuries was an important innovation.
“We knew we needed a way to tighten policy even when excess reserves were quite plentiful, and that’s what IOER gave us,” Kohn said. “I think IOER was critical to giving the open market committee and the board the confidence to engage in the kind of aggressive activities that limited the damage from the global financial crisis and promote recovery.”
But a side effect of those aggressive activities was that the elevated balance sheet — and, by extension, the heightened balances in Fed member bank accounts — essentially made IOER a permeable boundary. The federal funds rate has persistently fallen below IOER for most of the time that it has been enacted.
Kohn said that effect creates problems, but they are primarily optics. For example, he disagreed with the idea that IOER incentivizes banks to hold higher excess reserves, noting that other regulatory considerations, including the leverage ratio, encourage banks to hold as little in reserve accounts as possible. In reality, he said, the excess reserve balances are a product of the Fed’s balance sheet, and until that is drawn down the reserve balances can move and shift but never really disappear.
“Think it’s unfortunate in the sense that the Federal Reserve characterizes it as a ceiling, because really it's a soggy floor,” Kohn said. “I think one of the optical problems here is that the IOER is above the federal funds rate — it should be either at the federal funds rate or below in a corridor system. That looks like the Federal Reserve is giving a subsidy to the banks that are holding it.”
Chris Whalen, chairman of Whalen Global Advisors, agreed that the real issue with IOER is the Fed’s balance sheet. He said the Fed’s practice of quantitative easing — that is, buying distressed securities and keeping them on their own balance sheet in exchange for liquid capital — was initially successful in providing liquid capital to the banks. But as they kept going, they really created the problem that is now exemplified by the above-market IOER payments.
“QE1 was really about the Fed liquefying the banks, because they had lent them all this money and the banks didn’t have the liquidity to pay them back. Ever since then, the QE hasn’t done anything,” Whalen said. “The Fed institutionally has a problem, which is that they can’t admit an error. This clearly didn’t work, and now you’re telling me you’re going to maintain $4.5 trillion on your book?”
Abernathy said the Fed acknowledges the need for it to draw down its balance sheet — though the particulars are not resolved — and the expectation is that once the balance sheet is back to a reasonable level, the market for funds will rebound.
“The Fed does recognize that with their huge portfolio, the markets can’t be relied upon to set the low interest rate. The Fed admits that,” Abernathy said. “I think everyone recognizes that when the Fed’s huge portfolio gets worked down significantly, then the markets will return, and that’s how you solve the problem.”
The Fed’s preferred method of drawing down its balance sheet is simply not to renew securities as they mature, with an ultimate pace of around $30 billion a month in Treasuries and $20 billion a month in mortgage-backed securities reductions after a 12-month phase-in period. But it remains unclear whether Congress will insist on a faster pace, how it would so so and how disruptive a faster draw-down might be to markets.
Bill Nelson, chief economist at the Clearing House Association, said the relationship between IOER and the Fed’s large post-crisis balance sheet is often conflated, but if Congress is too prescriptive in its directions to the Fed, it could have serious consequences.
“How to run off its portfolio, or the speed at which to have the Fed run off its portfolio — to have Congress dictate that would be a really bad idea,” Nelson said.
He added that Congress could take some actions to compel the Fed to reduce its balance sheet on a schedule that the central bank would had a hard time resisting.
“All that I think would really be necessary is for Congress to clarify the language that authorizes the Fed to pay interest on excess reserves to say IOER must be materially below the prevailing funds rate or other overnight unsecured interbank rates,” Nelson said. “They couldn’t insist that that happen immediately … but I don’t see how that could possibly be inappropriate given that the law already specifies that interest on excess reserves can’t be above the general level of interest rates.”
But Michel said Congress could be far more pointed in its policy demands if it wanted — either limiting by statute what kinds of assets the Fed can hold, dictating a maximum balance sheet or a timetable for selling off its excess assets.
“You would have to say they have to sell this stuff off, they can only hold one type of asset, they have to hold only Treasuries, only short term Treasuries, [the balance sheet] has to be back to a certain percentage of the market by a certain date — they could do any of those things,” Michel said. “I’m not saying they will.”
Kohn argued that the best way to ensure that market disruption is kept to a minimum is to let the balance sheet roll off much the way the FOMC has suggested — a process that will admittedly take a long time. But moving faster brings its own risks, he said.
“They’re trying to do it in the least disruptive way possible by announcing that when the portfolio runs down, they’ll just allow things to run off — very, very slowly,” Kohn said. “It could take years to get to the point where there are few enough reserves in the system that the difference between the IOER and the Federal Funds Rate will be arbitraged out.”
Selgin acknowledges in his testimony that the policy he describes is deflationary and would "pose difficult challenges” if adopted. Among those problems is that during that adjustment period, the federal funds rate would likely “cease for a time to be a reliable indicator of the stance of monetary policy.”
But Michel said the Fed was able to mitigate the negative effects of moving toward the floor system of conducting monetary policy, so there’s no reason it couldn’t combine expansionary operations to counteract the contractionary effect of reducing its balance sheet.
“This was all supposed to be temporary from the beginning,” Michel said. “You’re talking about something that was outside the spirit of regular monetary policy ... and a lot of it was done in a way that was sterilized, so there’s no possible way that somebody could say you can’t undo it in a way that’s sterilized.”
Nelson said the risk of the Fed not moving fast enough in drawing down its balance sheet, in this circumstance, could have the unintended and disastrous consequence of inviting heightened scrutiny of its ability to pay IOER — and that is a risk the agency should not take.
“I’m a big believer in defending the Fed’s ability to pay interest on reserves,” Nelson said. “I just think that they’re going to lose it if they don’t separate that discussion from the balance sheet.”