- Through buying and selling securities, the Fed directly influences the amount of reserves in the system and the federal funds rate, an interbank lending rate for those reserves. In general, the Fed does not set interest rates.
- The Fed’s core operations boil down to the following:
o It creates money to buy things; and, conversely,
o It destroys money by selling things.
- This process gives the Fed direct control over the monetary base (currency plus reserves). All else equal, the larger the monetary base, the more loans banks can make. (i.e., the larger the broader money supply can become).
It’s worth repeating that the Fed does not simply make market interest rates whatever it wants them to be. Some Fed critics focus too much on the Fed’s ability to suppress interest rates, but as the expected rate of return on real economic activity rises (or falls) for reasons beyond the Fed’s control, all else equal, interest rates will rise (or fall).
This relationship could have a major impact on future Fed policy because, as interest rates rise, the Fed will have to raise the interest rate it pays on reserves.
If it fails to do so as the economy takes off, it runs the risk of rapidly increasing inflation because the monetary base – in particular, the amount of excess reserves – is now so high relative to historic norms. Raising the interest rate on reserves is now the Fed’s main tool for slowing the rate at which banks use those reserves to make new loans.
So let’s fast forward to 2017 and assume the economy has really started to expand. If interest rates then get back to historic norms, the IOR policy could become a huge problem, literally and figuratively.
Suppose under this economic growth scenario the fed funds rate rises to a reasonable 3.5 percent. (The long-term average fed funds rate is more than 5 percent.)
If the Fed doesn’t then raise the IOR rate, excess reserves would revert to what they’ve been historically: a pile of money that banks would prefer to lend out rather than hold in reserve.
Given the size of the base and the danger of inflation from excessive lending, the Fed doesn’t want this to happen.
Instead of raising the IOR rate, the Fed could rapidly sell off its MBS to reduce the amount of excess reserves. But the Fed would most likely try to avoid this option for two reasons.
First, a rapid sale of its MBS could endanger the capital position of banks holding similar MBS by causing those securities’ value to fall. Second, if the Fed sucks too much cash out of the system too quickly, it could squash the nascent expansion.
Alternatively, the Fed could raise the rate they’re paying on IOR.
Sticking to this same scenario of a 3.5 percent fed funds rate, we would expect a similar IOR rate. And such a rate translates into an IOR payment to financial firms of almost $100 billion, more than 10 times the current amount.
A transfer of this size from the Fed to financial firms will not sit well with most politicians, especially those with more of a populist streak. But that’s only part of the problem.
Each year, by law, the Fed remits any income not used to fund its operations back to the U.S. Treasury.
In 2013 and 2014, the total annual remittance to Treasury was $79.6 billion and $96.9 billion, respectively. (And similar amounts in 2011 and 2012.)
So, if rates rise to much more than 3 percent, Treasury would most likely lose out on a major source of revenue. (It is true the Fed would typically also start to earn higher interest rates in this scenario, but it is no longer holding any short-term Treasuries so it would have to buy those.)
When the federal government loses this source of funds while the Fed is simultaneously transferring more than $100 billion per year to large financial companies, it will become clear exactly why Federal Reserve independence is largely a myth.
The Fed would better serve the country’s interest– as well as its own – by beginning to methodically get rid of these excess reserves now, while it still can with minimal political difficulty.
- Norbert J. Michel is a research fellow specializing in financial regulation for The Heritage Foundation’s Thomas A. Roe Institute for Economic Policy Studies.