A brief note on the political crisis at the Fed

Note: This post first appeared on Patreon on 2 Jul 2018

I saw a Twitter exchange this morning that reminded me that the Fed is facing a political crisis due to its quantitative easing program. And I think this will limit the Fed’s ability to act in the next recession. That adds to the loss of fiscal and monetary policy space I mentioned last week. But since this is ‘political’, I am going to make my explanation brief.

Excess reserves mean you have to pay interest to banks

Here’s the tweet and response.

The Fed thought it could wait until next year to decide key questions that will shape how large a bond portfolio it maintains.

The market may be forcing those discussions sooner: https://t.co/Va7Lta1mnN

— Nick Timiraos (@NickTimiraos) July 1, 2018

Important story! Highlights two key frustrations Congress has with Fed. 1) size of the B/S itself (“central bankers are now central planners”) and 2) bipartisan criticism of rising IOER subsidies paid to banks. @TimDuy @sam_a_bell @bindersab @PeterContiBrown

— Potomac (@PotomacRC) July 1, 2018

This is about the Fed’s balance sheet. This is because the Fed’s quantitative easing policy flooded the banking system with reserves. Now banks are flush with reserves. So the Fed can’t just dial up the Fed’s Funds rate to raise rates. The Fed is now forced to pay interest on excess reserves to banks in order to raise interest rates.

See, the Fed’s control over the Fed Funds market is predicated on banks needing to borrow reserves. Normally, banks are forced to borrow reserves at the Fed’s rate, since the Fed is the monopoly supplier. But now with so many excess reserves, the demand line for reserve balances is vertical. Banks don’t need reserve balances to settle payments and meet reserve requirements.

So the Fed is forced to pay banks interest on those excess reserves to set a floor on interest rates.

The balance sheet issue is going to become radioactive

Did you catch the word “subsidies” in the tweet by PotomacRC? That’s where the problem lies. It’s irrelevant whether that’s the right terminology. What matters is that the Fed is paying banks to hold reserve balances and many observers are outraged by this. And these payments will increase the higher interest rates go.

That outrages people like PotomacRC, What’s more, what PotomacRC is saying is what many members of Congress from both sides of the aisle are saying. And there is no way the balance sheet will shrink enough to make this a non-issue anytime in the next decade. That makes the balance sheet issue radioactive politically.

I have suggested the Fed could step up its balance sheet normalization pace in order to tighten without having to use rate policy. The Fed would do this because it was concerned about inverting the yield curve. But doing so would also help defuse the balance sheet as a political issue.

At the same time, the Fed is desperate to raise rates because it wants to be able to use rate policy in the next downturn and not have to rely on unconventional policy like quantitative easing. I don’t think they have enough ‘rate ammunition’. In the last several downturns, they have needed an average of about 6 percentage points of cuts to effect the policy they saw fit. And in the last recession they hit the zero lower bound — which is why they started QE in the first place. So ostensibly, the Fed would have cut more if it could.

No one knows where this is headed

I wish I could tell you how this will play out. But I can’t because a lot of it is political. What I can say is that the Fed is boxed in here.

On the one hand, the Fed wants to get to a 3 or 4% Fed Funds rate to have the ammunition for the next downturn. And they want to achieve that goal to also stop people from complaining about the Fed’s low rate policy distorting the economy.

On the other hand, the higher rates go the more the Fed will pay in “subsidies” to banks in the form of interest on excess reserves. And the optics of that are bad politically. The Fed will want to dial down its balance sheet.

So the Fed is incentivized to both raise rates and reduce its balance sheet, if purely for political purposes. And, of course, doing so risks the Fed being too aggressive in policy and actually causing the next recession, rather than rebuilding its arsenal to fight that recession.

When that recession comes, likely, the Fed will get to zero rates again. And then it will be faced with a decision about how much QE to do and what instruments to use to effect that QE. This will also be a very political decision. And I believe the Fed will feel constrained to act and will delay acting for that reason.

With all of this happening, some Members of Congress might feel compelled to pass legislation to limit the Fed’s power.

In short, a political crisis is brewing at the Fed. The higher rates go, the more the politics on this issue will come into plain view.