Want to Reduce the Size of the Fed’s Balance Sheet? Eliminate Interest Paid on Reserves
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The Federal Reserve instituted the payment of interest on reserves on October 15, 2008, during the Great Financial Crisis. The motivating factor for this was that the federal funds rate was trading below the FOMC’s target rate. Banks had greatly increased their borrowing from the Federal Reserve. This created excess reserves (reserves in excess of then required reserves) in the banking system. These zero-yielding excess reserves put downward pressure on the federal funds rate. In order to induce banks to hold excess reserves and, thus, prevent the federal funds rate from falling below the FOMC’s target-rate level, the Federal Reserve began paying interest on reserves. By December 17, 2008, the FOMC had reduced the lower-limit of its target federal funds to zero. So, the Federal Reserve could have ceased paying interest on reserves because the FOMC’s target-level of federal funds rate was at zero, a level at which the actual federal funds rate could not fall below. Yet, the Federal Reserve persisted in paying interest of reserves.
The FOMC began raising its FOMC target-level of the federal funds rate above effective zero in December 2015. Yet the Federal Reserve persisted in paying interest on reserves, which it does today with a FOMC target level of the federal funds rate at 3.625%. In February 2009, the FOMC engaged in the first of a series of Quantitative Easing (QE) operations whereby the Federal Reserve added large quantities of securities to its outright holdings, culminating in the largest QE operation in 2020 during the Covid pandemic. On April 1, 2020, the Federal Reserve eliminated reserve requirements on banks. With the massive amounts of reserves created by the Federal Reserve since 2009 and with the elimination of reserve requirements in 2020, how is the FOMC able to maintain the federal funds rate above zero? It does so by the artificially-created demand for reserves resulting from the payment of interest on reserves by the Federal Reserve.
If Chairman Warsh wishes to reduce the size of the Federal Reserve’s balance sheet, I suggest that the Federal Reserve cease paying interest on reserves. Banks’ demand for reserves would fall significantly (but not to zero). This would enable the Federal Reserve to offload large quantities of securities in order to drain off the “excess” and unwanted supply of reserves. If the FOMC insists on continuing to conduct monetary policy through the federal funds rate, it could announce that it would lend reserves via repurchase agreements at the federal funds target level plus X basis points or it would borrow reserves via reverse repurchase agreements at the federal funds rate minus X basis points.
The Federal Reserve owns $6.4 trillion of securities outright of which $4.5 trillion are US Treasury securities. So, the Federal Reserve owns about 14-1/2% of total marketable Treasury debt outstanding. If the Federal Reserve is concerned about the market “digesting” $6.4 trillion of debt all at once, it could phase down the amount of reserves on which it would pay reserves over time. But one way or another, there is no reason why the Federal Reserve should continue to pay interest on bank reserves.
Paul L. Kasriel
AuthorMore in Author Profile »Mr. Kasriel is founder of Econtrarian, LLC, an economic-analysis consulting firm. Paul’s economic commentaries can be read on his blog, The Econtrarian. After 25 years of employment at The Northern Trust Company of Chicago, Paul retired from the chief economist position at the end of April 2012. Prior to joining The Northern Trust Company in August 1986, Paul was on the official staff of the Federal Reserve Bank of Chicago in the economic research department. Paul is a recipient of the annual Lawrence R. Klein award for the most accurate economic forecast over a four-year period among the approximately 50 participants in the Blue Chip Economic Indicators forecast survey. In January 2009, both The Wall Street Journal and Forbes cited Paul as one of the few economists who identified early on the formation of the housing bubble and the economic and financial market havoc that would ensue after the bubble inevitably burst. Under Paul’s leadership, The Northern Trust’s economic website was ranked in the top ten “most interesting” by The Wall Street Journal. Paul is the co-author of a book entitled Seven Indicators That Move Markets (McGraw-Hill, 2002). Paul resides on the beautiful peninsula of Door County, Wisconsin where he sails his salty 1967 Pearson Commander 26, sings in a community choir and struggles to learn how to play the bass guitar (actually the bass ukulele). Paul can be contacted by email at econtrarian@gmail.com or by telephone at 1-920-559-0375.