IOER on Trial

Today I watched the Fed Chairwoman in her semiannual testimony before the US House of Representatives.  The highlight, I think, was in the back and forth with her over the issue of Interest on Excess Reserves (IOER).  Representatives on both sides expressed their concern over what they perceive as subsidies to the big banks.  These too big to fail banks (meaning too big to exist for at least one of them), none of whom have been disciplined by the Justice Department nor excluded from the industry by the Fed over their role in precipitating the Great Financial Crisis, are being paid now 50 basis points in interest on something like $2.5 Trillion in excess reserves.  That is about $12.5 Billion dollars paid to huge banks for essentially doing nothing.  Much of that will make its way into bonuses for these same bankers held in such low opinion by our esteemed leaders (what does it mean to be held in low esteem by those who are themselves held in such low esteem?).

Yellen’s response was that IOER was an important tool for the Fed to be able to control rates in the prosecution of monetary policy.   She stressed that the Fed, through its holdings of securities (Treasuries and MBS purchased from these self same banks, in order to maintain the fiction that the central bank was buying in the secondary market and hence somehow not doing direct financing of deficit spending by the sovereign), was itself paid vast sums in interest and that this interest was paid to the Treasury and hence the taxpayer – many times what was paid to the banks in IOER.  In other words, don’t worry about how much we paid them, look at how much we paid you!

Of course the Representatives were not buying this, even those who actually understood what she was talking about, which I am sure was few.  Not the Chair, not the Ranking Member (one of the dimmest wits on the Hill).  So there is already a political uneasiness with this whole payment of interest to big banks for doing nothing.  And that is at a mere 50 basis points representing just over $10 Billion.  Now I ask, what would happen if the Fed was actually successful.  If the economy picked up and all the Fed hoped for and assured everyone would happen came to pass.  In order to keep those excess reserves from flooding out into the real economy and and leading to massive inflation in the real economy, as opposed to merely in asset prices, the Fed would find itself paying what, 100 basis points?  200 basis points, 300 basis points?  Whatever it is would have to be in excess of Fed Funds.  Fed Funds was more than 5% as recently as the middle of 2007.  That is not even 10 years ago.

Under such circumstances what might the hearing today have looked like?  Imagine the Fed was paying huge banks not $12.5 Billion at 50 bips, but $50 Billion at 200 bips or $100 Billion at 400 bips.  Now that $100 Billion she is so excited to have remitted to the Treasury and the taxpayer is all or substantially all paid out to bankers.  My guess is that there would be a calamitous uproar in Congress.  My guess is the Fed would face a significant threat to its independence.  So Ms. Yellen should be happy the economy is not expanding as it has in the past.  If so then does the fact she is so sanguine about paying IOER to bankers at the current level represent an admission of sorts that Fed policy has failed and in fact will be unlikely to work in the future?  If not, then Ms Yellen or her successor is likely to face an unpleasant  political reckoning in the indeterminate future.

UPDATE:  After thinking about this a little more the answer is that the only likely way the Fed Funds Rate target and hence IOER goes north of 2% in the near future is that the economy has rebounded such that the Fed needs to move rates up.  In other words their dream HAS come true.  In that case they would feel confident enough to allow their hoard of Treasuries and MBS to roll off the balance sheet as they matured so the pile on which IOER was being paid would shrink and the total payouts to banks would therefore fail to reach the catastrophic levels which would bring greatly enhanced political scrutiny.  Time shall tell how it plays out.

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