Our Unhinged Fed
If you haven't seen much of me on these pages lately, that's because I've spent most of the last few weeks feeding and grooming my favorite hobby horse: that's right, the Fed's policy of encouraging banks to hoard reserves by paying above-market rates on their Fed reserve balances.
Well, last Thursday morning I rode the old gal to Capitol Hill, where I put her through the paces before the House Financial Services Subcommittee on Monetary Policy and Trade, at its hearing on "Monetary Policy v. Fiscal Policy: Risks to Price Stability and the Economy." Mickey Levy of Berenberg Capital Markets, Eric Leeper of Indiana University at Bloomington, and Jared Bernstein of the Center on Budget and Policy Priorities, also took part.
Below I reproduce my five-minute spoken testimony, in which I attempt to summarize the twenty-two thousand word written testimony I submitted beforehand. All four written testimonies, including my screed, can be read here. Those who wish to see the entire show, including my and the other participants' replies to members' questions, will find a video embedded further below.
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Chairman Barr; Ranking member Moore; distinguished committee members: In October, 2008, the Federal Reserve began paying interest on banks’ reserve balances with it. My testimony today concerns the economic consequences of that step.
The Fed was originally supposed to start paying interest on reserves in 2011, to reduce the implicit tax burden reserve requirements placed on banks. But as the 2008 crisis worsened, the Fed received Congress’s permission to start paying interest on reserves immediately. Its goal then was, not to relieve banks of a required reserve burden, but to get them to hoard reserves it was creating by its emergency lending, so that that lending wouldn’t result in increased bank lending and inflation.
To make interest on reserves serve this role, the Fed set the rate on reserves above comparable market rates, where it has kept it ever since. It thereby ignored the laws' stipulation that the rate was “not to exceed the general level of short-term rates.”
As an anti-stimulus measure, interest on reserves worked very well: so well that within weeks the Fed did an about-face. Now it hoped to stimulate the economy by purposefully creating large quantities of fresh bank reserves. All told, the subsequent three-rounds of “Quantitative Easing” created another $2 trillion of additional bank reserves. Yet because reserves still paid an above-market rate of interest, banks just kept on accumulating them, as they had done — and as the Fed had wanted them to do — before QE, when it was worried about inflation.
If “insanity is doing the same thing over and over again but expecting different results,” then I fear it must be said that at least some Fed officials were not quite in their right minds.
Although the QE stimulus was disappointingly small, the Fed’s actions had other, big consequences. By acquiring trillions of dollars worth of Treasury and mortgage-backed securities, and borrowing from banks to pay for them, the Fed dramatically increased its footprint on the U.S. credit system. Before IOR and QE, bank reserves were less than 1% of bank deposits; bank loans, in contrast, were almost 100% of bank deposits. Today bank reserves are 20% of deposits, and loans are just 80% of deposits. Before IOR and QE, the Fed’s assets were 7% of commercial bank assets. Today the figure is 27%.
Commercial banks are expected to invest the public’s deposits productively, subject to certain regulatory guidelines. Central banks aren’t. They’re tasked instead with regulating the scale of commercial bank lending and deposit creation. According to the Fed’s own guidelines, as set forth in a pre-crisis publication, it is supposed to “structure its portfolio and … activities so as to minimize their effect on… credit allocation within the private sector.” The reason for this, the same guidelines state, is that hard-earned experience shows that “in general…market-directed resource allocation fosters long-run economic growth.”
In fact there’s a vast economics literature on what’s known as “financial repression.” The term refers to the harmful consequences of policies — mainly in less-developed countries — that divert savings from commercial banks to central banks, and thus from more to less productive uses. That literature blames such policies for much of the world’s poverty.
The Fed’s current operating system, with its above-market interest rate on reserves and bloated balance sheet, is very financially repressive. That is one reason for the continuing post-crisis “productivity slowdown.” Yet the same system, far from at least improving basic monetary control, has prevented the Fed for 5 years running from meeting the 2% inflation target it set in 2012.
Distinguished committee members, Chairman Barr, a central bank that cannot control inflation, and especially one that cannot make inflation go up, is a central bank that is unable to perform its most fundamental duty.
To close, the Fed’s new operating system, based on above market interest on reserves, has had disastrous consequences. Yet despite these consequences, the Fed’s current plan for “normalization” would keep much of the current arrangement in place. I hope, for the general public’s sake, that Congress will not let that happen.
