Since October 2008 the Federal Reserve has paid interest on bank reserves. It first introduced interest on reserves in the depths of the financial crisis, to prevent its emergency lending programs from creating excessive money growth and inflation. It continues to pay interest on reserves today, as it gradually reduces the size of its balance sheet even as it more rapidly raises its target for the federal funds rate. As soon as its asset holdings return to more normal levels, however, the Fed should cease paying interest on reserves. The risks entailed by a permanent interest-on-reserves policy more than offset the potential benefits.
The traditional argument for interest on reserves is based on microeconomic efficiency in the banking system. Milton Friedman advanced this argument in his 1959 book, A Program for Monetary Stability, drawing on logic outlined earlier by George Tolley in a 1957 article from the Journal of Political Economy.
Friedman and Tolley start by observing that, in a fiat money regime, the central bank can create an additional dollar of reserves at a resource cost that is, for all practical purposes, equal to zero. Microeconomic efficiency dictates that any good that is produced at zero marginal cost ought to sell at a zero price. Bank reserves, however, are a durable good: the analog to their “price” is the opportunity cost to each bank of holding an extra dollar in reserves. Friedman and Tolley conclude, therefore, by noting that the central bank can drive this opportunity cost to zero by paying interest on reserves at a rate that approximates those available on other safe and highly liquid assets, like short-term US Treasury bills.
Offsetting these efficiency gains, however, are two risks that come along with interest on reserves, neither of which was anticipated by Friedman and Tolley. The first risk is economic; the second is political.
The economic risk arises not directly from interest on reserves, nor even from the large size of the Fed’s balance sheet. The risk stems, instead, from the mismatch that currently exists across the Fed’s long-term assets and short-term liabilities. To see how this risk arises, imagine that the central bank pays interest on reserves, then satiates banks’ demand for reserves at zero opportunity cost by conducting large-scale open market operations. Suppose, however, that instead of using these open market operations to acquire long-term bonds, as the Fed did recently with its three rounds of quantitative easing, the Fed instead purchases very short-term US Treasury bills. This was the scenario originally envisioned by Friedman and Tolley, where the Fed pays interest on reserves and maintains a large balance sheet, yet there is no maturity mismatch.
In this counterfactual scenario, the Fed would not be generating the substantial surpluses it is earning today, because it would be receiving the same low interest rate on its assets that it is paying on its liabilities. On the other hand, there would be no risk of losses either, because even as the Fed raised short-term rates to tighten monetary policy, the interest rate it receives on its short-term assets would rise as well.
Instead, by issuing short-term liabilities in the form of reserves and buying long-term assets like US Treasury bonds and mortgage-backed securities, the Fed in practice has used interest on reserves to run what Marvin Goodfriend aptly calls “monetary policy as a carry trade.” Through this carry trade, the Fed earns unusually large profits so long as short-term rates remain low. Yet the Fed also exposes itself to the risk of losses if, to control inflation, it must raise short-term policy rates above the fixed rates it receives on its assets.
To minimize these risks, the Fed should wind down its carry trade by reducing the size of balance sheet as quickly as possible. Dispensing with interest on reserves as soon as balance sheet unwinding is complete will remove the temptation to re-initiate this risky carry trade in the future.
The political risks from the Fed’s interest on reserves policies loom even larger. Already Congress has drawn on the Fed’s surplus – consisting of profits from its carry trade – to help finance federal spending: once with the Highway Surface Transportation Act 2015, and again with the Bipartisan Budget Act of 2018. Each time this process gets repeated, the Fed appears less like an independent central bank, responsible for managing the money supply to control the inflation, and more like a fiscal agent that helps finance government spending. In our democracy, it is best that federal expenditures get paid for out of tax revenues or through the issuance of Treasury debt, not from risky financial transactions hidden on the Fed’s balance sheet. This provides another reason why the Fed should move, as quickly as possible, to reduce the size of its balance sheet and discontinue interest on reserves.
Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee.
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