Excess Reserves: How the FED Gets Taxpayers to Subsidize Banks
The Federal Reserve's Federal Open Market Committee meets this week. The Federal Reserve System governs monetary policy through this committee: the FOMC.
The FOMC is expected to announce today that it has raised the interest rate on payments it makes to commercial banks that have excess reserves on deposit at the FED. The FED does not invest these funds. They are the legal equivalent of paper currency in bank vaults. But, unlike paper currency, excess reserves are paid interest by the FED.
The FED pays the banks out of its revenue stream. Then the FED quietly passes these costs to the Treasury. The financial press rarely discusses this. Instead, it discusses the FED's latest announcement on "interest rates" (plural). None of these discussions begins with a discussion of the highly limited nature of Federal Reserve policy.
THE BIG FOUR
The FOMC can control only four factors directly: (1) the total nominal value of the assets held by the FED, i.e., the monetary base; (2) the rate of interest that the FED pays to commercial banks on their excess reserves held by the FED as deposits from these banks; (3) the federal funds rate; (4) the reserve ratios that apply to commercial banks.
That's it? That's it.
Can the Federal Reserve directly control interest rates (plural)? It can control this rate: excess reserves. It can also control the federal funds rate.
How important is the federal funds rate? Not very. Today, it is only a symbol. This has been the case ever since December 2008, when the FED began paying interest on excess reserves. The FedFunds rate used to be important as an indicator of the FED's degree of support of the banks. When a few banks suffered from an overnight shortage of reserves to sustain the legal limit on the dollar value of their loans (fractional reserves), they borrowed from other banks overnight. The FED stood as a lender of last resort. This set a ceiling on the FedFunds rate.
Today, the FedFunds rate is irrelevant. The nation's banks have deposited $2.1 trillion in excess reserves at the FED.
Almost every bank can meet the legal limit of the fractional reserves required by the FED. They do not borrow overnight.
The excess reserves rate sets the lower limit on FedFunds. No bank will lend overnight to another bank at a rate lower than the rate paid on excess reserves. Banks do not borrow at a rate above the excess reserve rate. They have plenty of reserves. The FedFunds rate is a shadow rate with no power to move the economy.
All talk about the FED's decision to "move interest rates" is misleading. The FED controls two rates directly, but only one is relevant: the rate paid on excess reserves.
The FED can also directly control the monetary base by buying or selling assets. I am including the arcane assets called repos. The FED makes policy decisions in terms of the monetary base. It cannot directly influence what commercial banks do with the monetary base. It can and does "nudge" the banks by changing what it pays as interest on excess reserves.
It can change the reserve ratios, but it never does. These were set in the 1980's. Any variation applies only to tiny amounts of money in banks. If the FOMC raised the ratios, this would reduce the money supply: M-1, M-2, M-3, MZM, etc. That would bring on a recession. The FOMC never suggests that it might raise reserve ratios. No analyst pays any attention to reserve requirements.
WHY THE FEDERAL DEFICIT WILL RISE IN 2019
Because the FED pays interest to commercial banks out of its own profits from purchasing assets, whenever it increases the rate, it forces a deficit on the government. The money that it pays to commercial banks will not be returned to the Treasury in January of the next calendar year. There is a one-to-one relationship between money paid to banks and the increase of the federal debt as of the next January. This inescapable fact of federal accounting is rarely discussed in discussions of the FED's interest rate policy. It is doubtful that more than a half a dozen Congressmen understand this. Maybe Rand Paul understands it in the Senate. Politicians never mention it.
One of the best discussions I have seen on this is an article on
At taxpayer expense: easiest, risk-free, sit-on-your-ass profit ever.
Then it explained.
The Federal Reserve's income from operations in 2017 dropped by $11.7 billion to $80.7 billion, the Fed announced today. Its $4.45-trillion of assets - including $2.45 trillion of US Treasury securities and $1.76 trillion of mortgage-backed securities that it acquired during years of QE - produce a lot of interest income.How much interest income? $113.6 billion.
It also made $1.9 billion in foreign currency gains, resulting "from the daily revaluation of foreign currency denominated investments at current exchange rates."
For a total income of about $115.5 billion.
That's the profit from legal counterfeiting, which the U.S. government authorized in December 1913. The author did not explain this, but he made it clear that taxpayers funded payments to the commercial banks.
When the Federal Open Markets Committee (FOMC) meets to hash out its monetary policy, it also considers what to do with the interest rates that it pays the banks on "Required Reserves" and on "Excess Reserves." In this cycle so far, every time the Fed has raised its target range for the federal funds rate (now between 1.25% and 1.50%) it also raised the interest rates it pays the banks on "required reserves" and on "excess reserves," which went from 0.25% since the Financial Crisis to 1.5% now
This is an accurate description. So, how does this constitute a taxpayer subsidy?
First, the FED covers its operating costs. Then it pays dividends to the shareholders, meaning large commercial banks (never identified) that own the 12 private regional Federal Reserve Banks: $784 million. Chump change, really. It also pays to run the Board of Governors: three-quarters of a billion dollars. Half a billion dollars funds the Consumer Financial Protection Bureau.
After everything has been taken care of, the Fed had a net income of $80.7 billion, which is tax free, of which it remits an estimated $80.2 billion to the Treasury:
So far, so good. Here is the kicker. The article presents a chart that shows falling remittances to the Treasury. Click here to see it. The author comments:
If the Fed hadn't decided to pay interest on excess reserves, to benefit the banks, it could remit this money to the Treasury. In other words, every dime the banks receive comes indirectly out of the pocket of taxpayers.
He's got it!
Now, if every other financial columnist could get it . . . and then report it.
Then comes the bottom line.
The Fed will likely raise rates further this year. There is talk of four rate hikes. This would push the rate on excess reserves to 2.5% by the end of the year. Excess reserves will likely shrink as QE is being unwound, but not fast enough. And the amount that the Fed pays the banks this year might surge to $40 billion or more — a glorious and hidden subsidy extracted from taxpayer pockets.
Hooray for Business Insider. It has alerted its readers to the crucial fiscal fact that should be reported widely in preparation for the meeting of the FOMC and the boilerplate press release that will follow.
CONCLUSION
The financial journalism guild is asleep at the wheel. I don't think most of them understand any of this.
Congress is also asleep at the wheel.
I am sure the FED chairs know, but they prudently do not mention this in public. Congressmen do not ask the chair when she/he testifies to Congress, as required by law:
"Why is the Federal Reserve proposing an increase in next year's federal deficit by paying commercial banks an even higher rate of interest for zero risk?""Why not pay this money to the Treasury to help the government deal with the deficit?"
"The Federal Reserve did not pay banks on excess reserves before December 2008. Why is it continuing a policy that was aimed at stopping the recession of 2009? Is there a comparable threat to the banking system today?"
As John Wayne said in The Searchers: "That'll be the day!"
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