With the December 2017 quarter of a percent hike in the Federal Reserve Bank interest rate to 1.5%, banks will receive 1.5% interest on reserves parked at the Fed instead of lending them out. Lending them out means added investment. Lending out the excess reserves means increased demand deposits at private banks. And increased demand deposits means more money supply as measured by the M1 aggregate of currency in circulation plus demand deposits.
With $2.1 Trillion in excess reserves now parked at the Fed, private banks on an annual basis will earn (0.015)($2.1 Trillion) or $31.6 Billion dollars. Fed minutes apparently show this 31.6 going to only 10 banks. That is $3.16 Billion being paid per bank on average by the Fed, outside of the Congressional Budget process.
Why? Interest on excess reserves (IOER by its acronym) was begun by the Fed in October 2008 at the height of the financial crisis. At first substantial interest was paid for excess reserves. (See Federal Reserve Data at https://fred.stlouisfed.org/series/IOER ). Once the liquidity crisis passed, the Fed kept paying such interest and excess reserves, which are those reserves greater than what banks are required to hold, began piling up. They reached $2.6 Trillion and now are finally starting downwards, standing at $2.1 Trillion. In contrast, required reserves are the 10% of demand deposits that are held as reserves at the Fed (Dodd-Frank 2010 legislation changed some reserve requirements, but this is irrelevant here).
When the Fed buys Treasury debt, the money multiplier occurs as this creates excess reserves that are lent out until only the required reserves are held. But the Fed has induced “moral hazard” by paying banks not to lend out reserves. This increases the probability of the bad state, which is too low of an investment level, even after the crisis has passed. So the money multiplier is suppressed. Excess reserves earn interest instead of loans by banks and investment by firms earning market interest rates.
By raising the “interest rate” in December, the Fed is not raising the Federal Funds rate. It is raising the interest rate on excess reserves: the IOER. The Federal funds market is basically defunct since it is used by banks to borrow from other banks in order to meet their weekly required reserve level. Now reserves are in excess.
If all of the excess reserves are lent out now, inflation will increase above the Fed’s 2% target. So the Fed does not advertise the off-the-federal-budget expenditure that it makes exclusively to the private bank sector. The Fed has become a drug addict: it keeps raising the opioid amount that banks receive every time it increases interest rates. Private banks are happy. The Fed is happy since its inflation target of 2% has not been exceeded nor is its ability to meet its target seriously threatened (generally meaning that the inflation rate is 2% or less). Ironically the Fed has not been able to understand why inflation had been low, below 2%, for so long. It is because they have paid banks not to lend out money, which the Fed knows of course.
The Catch 22 is that if the Fed stops paying IOER, the excess reserves will get lent out and the inflation target gets a miss. Too bad. An immediate ceasing of the subsidization of the bank sector should begin as soon as possible. Jerome Powell knows of this, but has he either the moral fiber, a consensus over the issue, and/or the courage to stop it, by himself? Probably not.
Yes the inflation rate would jump, but not for so long. Then interest rates could be truly normalized, with a normal positive real interest rate. This means the short term Treasury Bill rates rise above the inflation rate.
Why was interest on reserves begun? Long story. Economists argued that if we “tax” banks by making them hold reserves at the Fed, then we should decrease that tax by paying interest on the REQUIRED reserves. Even this would be a subsidy. Why? Because banks would hold say 7% of reserves anyway. So the tax is only on the 3% extra amount of reserves held when 10% of deposits are held as reserves. But the Congress passed a 2006 law (Financial Services Regulatory Relief Act) allowing the Fed to pay interest on reserves, starting in 2011. Here the intent was to pay interest on required reserves, as consistent with the academic debate on whether this was a good idea or not. Interest paid on excess reserves was not part of this debate (although some might debate this). Of course banks favored this interest on required reserves. It is still a subsidy to banks since they would have held some zero- interest earning reserves anyway as a natural part of running a financial institution. Crisis hit in 2008 and the law was allowed to start in 2008.
Most insidiously of all, the Fed allowed interest to be paid on all reserves, not just required reserves. This began the Fed’s complete control over the Federal Funds market. In order to avoid appreciating against the US dollar, major trading partner countries followed the US and increased their money supply in order to create a persistent liquidity that suppressed short term interest rates, while inflation was above these rates. This achieves negative real interest rates, matching the US and avoiding currency appreciation.
Here a study of the Swiss National Bank actions is recommended (at first they appreciated and then started printing money and buying anything they could, now owning a substantial share of the Swiss private sector: because they had little government debt to buy).
Going Cold Turkey on IOER, and setting it to zero, is the easiest way out of the Fed’s morass, its quagmire, its “illegal” subsidization of the private bank sector. Sure. Pay interest on REQUIRED reserves, but not on excess reserves. That policy, paying IOER, causes moral hazard. The increase in the probability of the low investment “state” of the economy has caused the Lost Decade that the US is finally exiting. Let it exit it completely and stop the Fed’s direct revenue subsidization of the “Lucky 10” private banks who get the IOER. $31 Billion is a lot of money to any private company, especially free money from the US government.