Federal Reserve Chairwoman Janet Yellen and the rest of the central bank will face new risks of populist criticism in 2016 and beyond, as it aims to raise interest rates by paying potentially hundreds of billions of dollars to banks for holding reserves at the Fed.
The Fed has paid banks to hold excess reserves at the central bank since 2008, but the payments have not attracted much political attention, partly because the rate it paid, 0.25 percent, was close to zero. In December, however, the central bank raised the rate to 0.50 percent as part of its effort to lift its interest rate target from zero. Current projections from the Fed’s monetary policy committee members have the rate rising above 3 percent in the next three years.
In that scenario, the Fed could be paying banks close to $100 billion annually for keeping reserves at the Fed. That, in turn, would pose special political risks to the central bank and its independence, just one of many difficulties that Yellen and company must navigate in the years ahead in trying to return the country’s monetary policy to normal.
“It’s going to become a political nightmare,” said Norbert Michel, a scholar at the conservative Heritage Foundation. After raising rates, the Fed will be “shoveling out billions of dollars to big banks, and Elizabeth Warren’s not going to like that,” he said, referring to the Massachusetts Democratic senator known for her strident criticism of Wall Street.
The central bank’s plan for relying on the interest rate it pays on excess reserves to set short-term rates is new.
Before the financial crisis, the Fed raised and lowered rates by buying or selling securities in a market that banks participated in to ensure that they had enough reserves to meet regulatory requirements each night. By buying or selling, the Fed could affect scarcity and thereby set rates.
That’s no longer possible. After offering to pay banks for reserves in excess of the regulatory requirements, the Fed saw a massive influx of reserves from banks with few other options during the financial crisis. Currently, banks have stored $2.4 trillion in such excess reserves at the Fed.
Managing such a huge amount of reserves is “not sufficiently nimble” for implementing precise changes in the Fed’s target rate, the central bank’s staff wrote in a paper published earlier this year. Furthermore, the staff concluded, it would be difficult for the Fed to communicate to the public what it was doing and why.
As a result, Fed members decided after debate in 2011 and 2014 that they would rely mainly on the interest rate on reserves to raise rates when the time came, counting on arbitrage to raise other short-term rates with it.
In its December monetary policy statement announcing a quarter-percentage point increase in its interest rate target, the Fed ruled out shrinking its balance sheet until rate hikes were “well under way,” meaning that it plans for large quantities of excess reserves to remain parked at the Fed.
Although the product of careful thought, the plan will involve greater payments to banks, including foreign banks, at a time when the public is still resentful of the 2008 bailouts.
For example, Goldman Sachs, one of the largest U.S. banks, earned nearly $120 million through the first three quarters of this year alone, according to federal records.
More politically worrying than the appearances of the Fed paying banks, said Peterson Institute for International Economics fellow Joseph Gagnon, is the possibility that the Fed could suffer losses while paying out billions to banks. Losses of dozens or hundreds of billion a year, although meaningless from the Fed’s point of view, could unnerve the public and erode confidence in the central bank.
“There could be a year in which they lose money, and that could be politically troublesome for them,” said Gagnon, who previously worked on the staff of the Fed’s Board of Governors.
Losses on its $4.5 trillion portfolio are not a problem for the Fed, which doesn’t have to recognize losses and can easily manage its finances to avoid any disruptions to conducting monetary policy that would stem from losses.
Furthermore, in the years since the crisis, the Fed has earned hundreds of billions for the U.S. Treasury with its large holdings of Treasury securities and mortgage-backed securities. The Fed sent nearly $97 billion to taxpayers in 2014 and just under $80 billion in 2013. Those payments should be considered with any potential future losses, former Fed Chairman Ben Bernanke said in 2013 when asked about the Fed’s exit strategy in a House hearing.
Nevertheless, it’s a potential risky area for the Fed, especially given the large number of lawmakers eager to criticize the central bank and draw attention to developments that cast it in a negative light.
Most recently, Sen. Ted Cruz, the Texan seeking the GOP nomination for the presidency, challenged Yellen about payments to banks for excess reserves, asking her during a December hearing “what has the impact been of paying billions of dollars to those banks in the last seven years?”
Yellen responded with classic Fedspeak, telling Cruz that paying interest on excess reserves “has helped us to set interest rates at levels that we thought were appropriate for economic growth and price stability in this country.”
The Fed will have to do better explaining why it is paying banks and why losses wouldn’t be a problem, Gagnon said. “They should get out in front so that people realize this is not unexpected and not a bad thing.”
