January 12, 2016

Let’s start with a few uncomfortable facts.

If the Federal Reserve maintains the fed funds rate at its current level (0.25%) for the rest of 2016 and there are no further interest rate rises during 2016, then the Fed will donate more money to foreign and domestic banks during the course of 2016 than the US Government will spend on the entire National School Lunch Program.

If the Fed raises interest rates to 1.0%, then the Fed will give away nearly as much money to foreign and domestic banks in a year as the US Government spends on the Federal Pell Grants program. The Pell Grant program is a massive $40+ billion per year program that provides needs-based grants to over 5 million college students, or one third of the entire college student population.

If the Fed raises interest rates to 2.5% by using interest on reserves, as is current practice, and if it maintains banks reserves at roughly current levels (as the Fed has indicated it will for the time being), then the Fed’s new bank welfare program will be as large as the US Government’s entire food stamps program.

Yes, you read that right.

If the Fed raises interest rates to 2.5%, a level that is low by historical standards, then the Fed will pay out 2.75% on its $2.67 trillion in reserves, or roughly $73.5 billion per year to foreign and domestic banks.

In contrast, the Supplemental Nutrition Assistance Program (“SNAP”) that provides food assistance to roughly 46.5 million Americans, including one in every four children in the United States, cost taxpayers an almost identical $74.1 billion per year in FY 2014.

The worse aspect of all this is that, from an economic perspective, the Fed’s new bank welfare program, otherwise known as “interest on reserves”, is totally unnecessary.

While there is no question that the Fed must begin the process of reversing nearly a decade of excessively easy monetary conditions, the Fed doesn’t need to do it by handing out money to banks. Rather, the Fed should begin the process of tightening monetary policy by unwinding another implicit subsidy to corporate America, namely “quantitative easing”.

If the Fed unwinds QE, i.e. reduces the size of the monetary base by selling assets from the Fed’s bloated balance sheet, then long-term interest rates will begin to rise. If the Fed waits until this process of balance sheet reduction is largely complete, then the Fed will not need to use interest on reserves (“IOR”) and reverse repurchasing facilities (“RRP”) to raise the fed funds rate and will not have to donate billions of dollars every year to banks.

“Interest on Reserves”: A Little Background

The first point that needs to be made about the “interest on reserves” program is that the practice of paying interest on reserves is new.

Why does this matter? Well, prima facie, it raises an obvious question. If the Fed spent nearly 100 years raising interest rates without finding it necessary to pay interest on the reserves held by banks at the Fed, then why does it suddenly need to do this now?

Throughout the history of the Federal Reserve System, major banks in the United States have been required to hold a minimum amount of reserves at the Fed. In effect, this was money that the Fed forced commercial banks to put in the “penalty box” in anticipation of the mistakes that the banks would inevitably make, i.e. being too aggressive in making loans.

Historically, the Fed never paid interest on these reserves. Indeed, the Fed had no authority to pay interest on reserves until Congress passed the Financial Services Relief Act of 2006.

Did this inability to pay banks interest on their reserves at the Fed impede the ability of the FOMC to raise interest rates prior to 2006? No. For decades, the Fed was able to raise interest rates without paying interest on reserves, i.e. the Fed was able to raise the fed funds rates without directly handing money over to banks.

So, what changed? If you ask FOMC members today, they will claim that they need to pay interest on reserves in order to be able to raise the fed funds rate. But why is this the case? And does this claim by the Fed represent the whole truth or a disingenuous half-truth?

Technically, the justification used by the Fed for the introduction of interest on reserves is as follows:

“This (the introduction of interest on reserves) was important for monetary policy because the Federal Reserve’s various liquidity facilities initiated during the financial crisis caused upward pressure on excess reserves and placed downward pressure on the Federal funds rate. To counteract these pressures, on October 6, 2008, the Federal Reserve Board announced that it would begin paying interest on depositary institutions’ reserve balances.” [See “Federal Reserve Bank of San Francisco, Dr. Econ online section”]

OK, now let me translate that.

In response to the financial crisis of 2008, the Fed introduced a series of extraordinary and unorthodox policy measures, most notably quantitative easing or “QE”. In essence, quantitative easing entailed the creation of roughly $4 trillion in new money by the Fed and that money was then used by the Fed to purchase fixed income government securities.

By purchasing trillions of dollars worth of fixed income securities, the Fed forced down interest rates across the entire US government yield curve, making it very difficult to raise short-term interest rates using traditional means. Moreover, the banking system was suddenly awash with “excess liquidity”, most of which found its way into something called “excess reserves” held at the Fed. With so much money sloshing around in the “excess reserves” bucket, i.e. reserves held at the Fed that are not technically required to be held there, it made it all but impossible for the Fed to raise the fed funds rate using traditional means.

In other words, the Fed suddenly couldn’t raise the fed funds rate using conventional means because it had boxed itself into a corner. The Fed had pushed interest rates so low across all maturities that the only way it could raise the fed fund rate was by paying banks interest on the reserves that they kept at the Fed.

Now, let’s reexamine the claim that the Fed must use interest on reserves in order to raise interest rates. Is this the whole truth or a disingenuous half-truth?

Clearly, it is a half-truth. Yes, it is true to say that if the Fed maintains the current size of its balance sheet, then it can only raise the fed funds rate by using the interest on reserves facility.

But, this avoids the key issue.

Namely, why is the Fed trying to raise the fed funds rate at a time when its balance sheet is overloaded? Why doesn’t the Fed get out of this mess the same way it got into it, i.e. sell the assets it acquired through the QE program, allow the yield curve to normalize and then raise the fed funds rate using conventional methods?

It would be one thing for the Fed to pursue this erroneous policy (interest on reserves) if it had no social consequence. But it does have a social cost. In essence, it is a “Reverse Robin Hood” policy. The interest on reserves program introduced in 2008 by the Fed takes money from ordinary American taxpayers and gives it to banks. Not just domestic banks, but also foreign banks.

Is It Real Money?

There may be some people who read this article that might claim that the money the Fed gives to banks under the interest on reserves program is somehow not the same as the money that the US government spends on social welfare programs, i.e. the two aren’t comparable because one is real money being “given away” (food stamps) while the other is just some fancy handwork of ivory tower economists.

This claim is nonsense.

The fact of the matter is that the money that the Fed donates to the banks under the interest on reserves program is identical to the money that the US government uses to fund social welfare programs.

To be clear, I am not making any value judgments here. Rather, this is simply a question of accounting. Let me explain.

If you go to page 105 of the Fed’s FY 2014 annual report and look at the financial statement on that page, you will see at the bottom of that statement a line called “Earnings remittances to the Treasury”.

What are “Earnings remittances to the Treasury”? In effect, this is the profit that the Fed makes for the year. What does the Fed do with its profit? It sends it to the Treasury. [How does the Fed make a profit? It buys bonds and earns interest on those bonds, less a few staff costs.] Looking at our table, we can see that the Fed sent the Treasury $96.9 billion in FY 2014. Somewhere in the Treasury’s FY2014 accounts, you will find a matching entry recognizing the receipt of those funds from the Fed.

The key point is that any “profit” made by the Fed is sent back to taxpayers via a remittance to the Treasury.

What impact does the interest on reserves program have on this profit? Clearly, if the Fed pays interest on reserves to banks, then this is money that must be deducted from its annual profit. Consequently, the US Treasury receives less money from the Fed.

In essence, paying banks interest on the reserves they hold at the Fed has the same impact on the finances of the US government as any other hike in government spending. It is simply more money that the American taxpayer has to hand over to cover the random misadventures of policy makers.

[Note: this actually slightly understates the adverse impact of the interest on reserves program because it adds an additional cost to taxpayers: namely, short-term government debt becomes more expensive to issue as short-term interest rates rise in line with the fed funds rates].

The bottom line is that if the Fed does nothing else this year, then based on its current policy setting (0.25% interest rate and roughly $2.7 billion in reserves), the Fed will give away more than $13 billion to foreign and domestic banks. This $13 billion is real money. It is money that could be used to finance the entire annual cost of the National Schools Lunch Program (the program cost $11.6 billion in FY 2012).

[How does the math work? The key point to remember is that the interest rate the Fed pays on reserve balances is 25 basis points more than the fed funds rate, i.e. if the fed funds rate is 0.25%, then the Fed actually pays 0.5% on all bank reserves held at the Fed. Why? Good question. The answer is we don’t know. Theoretically, it allows the Fed to keep interest rates in a “range”. But frankly, 25 basis points seems unnecessary. Put it this way: if the Fed lowered the premium from 25 basis points to 5 basis points it would save taxes payers $5 billion per year!]

Perhaps more astoundingly, is how quickly the numbers get really serious if the Fed continues on its current path.

While the numbers should be treated as indicative only, the fact is that if the Fed maintains the current size of the monetary base and bank reserves remain at current levels, and if the Fed raises the fund funds rate to 2.5%, a level that is low by historical standards, then the Fed will give away roughly $70-80 billion per year. That is a lot of money by any standards. In fact, it’s enough to pay for the entire Supplement Nutrition Assistance Program, formerly known as the Food Stamp Program.

Why is the Fed Avoiding the Key Issue?

While the social justice argument against the Fed’s new interest on reserves program is strong, there is an even stronger case to be made when it becomes clear that the entire program is not only unnecessary but represents bad economic policy.

If you listen to most market commentators, then you probably believe that the key issue facing the Fed today is whether the Fed should raise interest rates, or more specifically, the feds fund rate. It isn’t.

As discussed in last week’s post, “The Interest Rate Rabbit and the Base Money Elephant”, the Fed may want the markets to believe that its actions on the fed funds rate are the key to monetary policy, but in truth these actions are a diversion from the real issue. The real issue is this: “Why isn’t the Fed reducing the size of the monetary base?”

Over the past eight years, the Fed has quintupled the size of the monetary base. This is an extraordinary action and represents a massive departure from historic practice. As discussed earlier, this action led to a decline in both short-term and long-term interest rates. Moreover, it put tremendous downward pressure on the fed funds rate to the point that traditional measures that were used to raise the funds fund rate are no longer effective.

The question that needs to be answered by the Fed is why doesn’t the Fed begin the process of tightening monetary policy by reversing out of this situation the same way got into it, i.e. by reducing the monetary base before its raises the fed funds rate?

Instead of adopting new methods to raise the fed funds rate (interest on reserves and reverse repurchasing facilities), why doesn’t the Fed simply unwind its balance sheet, allow the market for US government debt to operate freely and then begin the process of raising the fed funds rate in the traditional manner, i.e. without throwing money at the banks?

The view of The Money Enigma is that the Fed should begin the process of tightening monetary policy by dramatically reducing the size of the monetary base. Such a reduction in the monetary base would have largely the same desired impact on the economy as any hike in the fed funds rate. Moreover, there are two compelling economic reasons for why an immediate reduction of the monetary base is required.

First, the dramatic expansion in the monetary base has created a series of severe financial market distortions, or what some might call “bubbles”. By using newly created money to buy government bonds, the Fed has reduced the required rate of return on assets, thereby boosting prices of both less risky assets (bonds) and high-risk assets (stocks). While the immediate beneficiaries of this largesse might be happy today, this type of financial market distortion endangers the efficient operation of markets and the long-term economic future of our society.

The second reason is more theoretical, but far important. It is a subject that was addressed at length in a post written nearly nine months ago titled “The Case for Unwinding QE”.

In essence, the current level of the monetary base heightens the risk that, at some point in the next five years, the value of the US Dollar will collapse and the rate of inflation will surge.

At this point in time, markets believe that the dramatic expansion of the monetary base is only “temporary” in nature, i.e. the Fed will reduce the size of the monetary base eventually. However, if markets start to realize that the current level of the monetary base is more “permanent” in nature, then this could precipitate a sudden decline in the value of the dollar and a surge in prices.

Why is this the case? Well, the view of The Money Enigma is that fiat money is a proportional claim on the future output of society. In simple terms, this means that, over long periods of time, the value of a fiat currency tends to track the “real output/base money” ratio. If we are sitting here ten years from now and the monetary base is still at its current level while real output has only grown modestly, then it is very likely that the value of money will have fallen significantly.

Readers who wish to read more about this theory are encouraged to visit the “Theory of Money” section of the website and/or read a post titled “Does Too Much Money Cause Inflation?”

In summary, given these social and economic considerations, it is astounding the Fed is choosing to adopt interest on reserves as a key policy, rather than simply reversing QE and reducing the size of its balance sheet. It may be that the Fed simply wants to appear to be “doing something”. But “doing something” isn’t the same as “doing the right thing”.