The Hidden Price of the Fed’s Rate Hike

March 16, 2017

Federal Reserve Chair Janet Yellen said yesterday that “the economy is doing well” as she announced the Fed’s third benchmark rate hike since the Great Recession. Yet there are important arguments against the rate hike: Unemployment hasn’t fallen to the level it reached in the late 1990s; wages are still stagnant; people of color are still unemployed at much higher rates than white workers. So it may be far better to let the economy “run hot” (i.e., risk a bit of inflation) than to lock in this labor market for the long term.

There’s also another key issue that’s discussed far less frequently: Increasing the target rate means increasing the interest payments that the Federal Reserve makes on the excess reserve balances that private banks hold with the Fed.[1]

These payments aren’t small change. Back-of-the-envelope math tells us that the Fed paid an average of $8 billion a month in excess reserve interest payments just since January of 2014—and payments have been above $10 billion per month since the Fed raised the core rate in December 2015.[2] Should these payments continue, as the benchmark rate rises and the economy is judged to be “doing well?”

Banks are required by law to hold a certain level of reserves to support their lending activities, and the proportion of total reserves required depends on the level of such activity. When the Fed buys or sells financial assets to a private bank, it pays for that asset by crediting the bank’s reserve account; in a sense, the Federal Reserve serves as the bank of private banks. If a bank increases its lending to private businesses and households but keeps its total level of reserves the same, the proportion of excess reserves that it is holding (versus required reserves) will fall—which you’d think would be a good thing.

During the financial crisis, the Fed conducted aggressive monetary policy by taking massive amounts of financial assets off of the balance sheets of private banks, paying banks for them by crediting their reserve accounts. This increased excess reserves by many orders of magnitude. And in October 2008, the Fed started paying interest to the banks on those excess reserves, just like a bank would on the deposit balance of any customer, because ostensibly banks didn’t have control over how big the reserve balances were getting.

Prior to fall 2008, total reserves had fluctuated between $40 billion and $60 billion; for the previous five years, required reserves had never accounted for less than 80 percent of total reserves. By late 2008, excess reserves alone had reached $850 billion; by 2012, commercial bank reserves at the Fed had reached $1.6 trillion, far in excess of required reserves, and more than 10 percent of U.S. GDP.

The Fed argued these payments were necessary during the recovery for two reasons. First, because without them, banks would lend too much to the private sector and cause another round of speculative lending activity. In other words, the economy wasn’t healthy enough to handle increased lending, and so banks needed to be compensated for the excess reserves that they were holding. Second, the interest rate helped set a floor relative to the Fed’s core policy tool, the federal funds rate.

But what about when the economy recovered? The Fed continues to pay positive interest on the banks’ excess reserves (and required reserves), resulting in an obvious source of risk-free profit that banks have, reasonably, pursued. Some economists argue that this has led to a retrenchment from productive lending and a decline in business investment—because why take risks in lending out money when banks can get a return on it for doing absolutely nothing?

Nearly 10 years post-crisis, the payments continue, and the argument now is that this is a necessary part of the Fed’s monetary policy toolbox. But paying interest on excess reserves wasn’t a policy tool of the Fed before 2008 (even though Milton Friedman started arguing for it 40 years ago). Should these payments continue indefinitely, even as Chair Yellen tells us the economy has recovered and the target rate will continue to rise?

The interest rate on excess reserves fluctuates along with the Fed’s benchmark rate: It held steady from 2009 at .25 percentage points until the Fed raised rates for the first time at the end of 2015, and subsequently jumped another quarter of a percentage point to .75 earlier this year; now it will rise to 1 percentage point. Even as the quantity of excess reserves fell through 2016 because of the higher rates, the level of payments continued to rise.

Rather than continue to incentivize such holdings, the Fed could simply reduce its interest payments and, in theory, induce banks to hold fewer excess reserves and engage in more lending activity. The Emergency Economic Stabilization Act also gives Congress the authority to take away the Fed’s ability to pay interest on excess reserves.

A more aggressive policy move would be to impose a tax on excess reserves (in the form of a negative interest rate).[3] The argument is that taxing excess reserves (and not required reserves) would serve as a strong incentive for banks to loan out more money (or possibly to return deposits). This is because as they increased their private lending, some proportion of their excess reserves would become required reserves to support that higher lending activity, and those reserves would not be taxed. This policy only makes sense if there are socially valuable lending opportunities that currently aren’t being funded, because forcing banks into increased speculative and risky lending activities is counterproductive. But so is spending billions of public money on private banks to encourage hoarding that keeps investment in the real economy low.

[1] The Board of Governors has PRESCRIBED RULES governing the payment of interest by Federal Reserve Banks in Regulation D.
[2] Author’s calculations of Federal Reserve data.
[3] For further discussion see Edlin and Jaffe (2009); Pollin (2012).