A question on paying interest on excess reserves came up during Janet Yellen’s recent congressional testimony.

Bloomberg writer Peter Coy offered this Q&A on a Fed Practice that Mystifies Congressmen. However, Coy blew many of the answers.

Coy: Federal Reserve Chair Janet Yellen ran into a bipartisan buzzsaw today over why the Federal Reserve is paying interest to banks on the trillions of dollars in reserves that they hold at the Fed. She tried repeatedly to supply the central bank’s reasoning but didn’t seem to make a dent.Here’s an explanation of the Fed’s position, which didn’t exactly come through in the sound bites under the bright lights of a congressional hearing.

“Please, please explain,” Representative Maxine Waters (D-Calif.), the ranking Democrat on the House Financial Services Committee, said at one point. Committee Chairman Jeb Hensarling (R-Texas) said the Fed’s interest-paying policy “can distort resource allocation and constrain economic opportunity.”

Coy: Here’s an explanation of the Fed’s position, which didn’t exactly come through in the sound bites under the bright lights of a congressional hearing.

Q: What are excess reserves?
Coy: Excess reserves are ones that banks hold in excess of the ones the Fed requires (obviously). At last count, a little more than 93 percent of bank reserves were excess. In January, excess reserves totaled about $2.3 trillion.
Mish: No problem with that answer.

Q: Why so much “excess”?
Coy: During and after the financial crisis, the Fed bought trillions of dollars in Treasuries and mortgage-backed securities. It didn’t pay for them with wads of bills. Instead, it simply credited the sellers of the securities with bigger reserves at the Fed. So now banks have way more reserves than they could possibly use.
Mish: Essentially correct

Q: And that’s a problem?
Coy: Yes, because the Fed can’t conduct monetary policy the traditional way. In the past, if the Fed wanted to push up interest rates, it would sell a bunch of Treasuries. Banks would pay for the Treasuries by using money in their reserve accounts. That would leave them short on required reserves. To replenish their reserves they would borrow reserves from other banks at a well-known interest rate: the federal funds rate. That won’t work any more because the banks have so much in excess reserves that any Treasury purchases they made wouldn’t make a dent in the total.
Mish: Sort of. The Fed could have and should have acted to shrink its balance sheet before it hiked rates in December. Instead, the Fed kept its balance sheet over $2 trillion. Next the Fed waited too long to hike as we have seen, but that is a different issue.

Q: So why exactly is the Fed paying interest on excess reserves?
Coy: As a way to raise short-term interest rates, to keep the economy from inflationary overheating. The idea is that if banks can stash money at the Fed at 0.5 percent interest, they won’t lend to anyone else for less than that. The rate sets a floor on market rates. (Not a hard floor, because some lenders aren’t eligible to earn the Fed’s rate, but that’s the general idea.)
Mish: The Fed wants banks to lend. It is nowhere close to worrying about the economy overheating. Thus, paying interest on reserves is free money to the banks.

Q: Why doesn’t the Fed just go back to the old way of doing things?
Coy: Because it can’t do so without getting rid of all those excess reserves that render ordinary monetary policy ineffective. The only way to go back to the old way would be to sell trillions of dollars in securities back to the market. As Yellen told the House committee, attempting such a massive sale right now “would be very disruptive to the economy.
Mish: Perhaps it would be disruptive “now” if done in one massive swoop. But done slowly between 2012 and 2014 as part of its explained policy, the Fed could have and should have drained those securities from its balance sheet. Yellen was quite a bit disingenuous with her answer and Coy failed to notice.

Q: Doesn’t paying interest on excess reserves encourage banks to hoard reserves?
Coy: The banks don’t really decide how much reserves they have. The Fed controls the level of reserves by buying and selling Treasuries and other securities. (That’s how reserves got so big in the first place.) So, no risk of hoarding.
Mish: Correct

Q: But is it fair for the banks to be getting all those interest payments?
Coy: That’s debatable, but here’s the case: The Fed is earning interest on all those Treasury bonds it owns. So much interest that it’s been forking over about $100 billion a year in profits to the Treasury each year, which helps narrow the federal budget deficit. You can think of the interest on excess reserves as the Fed’s payment for the assets it bought. If it didn’t pay any interest on reserves, it would essentially be getting those assets for free. Which also seems a bit unfair.
Mish: Quite frankly, that explanation is ludicrous. The Fed does collect interest on its balance sheet but that comes directly from taxpayers as interest on debt. Returning interest the Fed collects to the Treasury only narrows debt to the tune it increased the debt in the first place! The Fed does not return all the interest it collects. Some goes to staff, meetings, research etc. The most galling part of the equation is that instead of returning more money to the Treasury, the Fed gives a huge handout to the banks.

Bonus Mish Question

How big is the free handout to banks?

If excess reserves are $2.3 trillion and the Fed pays interest to banks at 0.5%, then the answer is $11,500,000,000!

That amount will rise every time the Fed hikes until the reserves are drained.

Mike “Mish” Shedlock