MONETARY AND FISCAL HEADWINDS TO SUSTAINING THE RECOVERY.

• Author: Gramm, Phil

A massive housing bubble--the product of a 15-year concerted federal effort to pressure banks to make subprime loans, and force Fannie Mae and Freddie Mac to buy and securitize subprime loans and incentivize banks to hold them as capital--burst in the fall of 2008. The asset base of the world's financial institutions crumbled as the value of mortgage-backed securities (MBSs) collapsed and credit markets froze. Following traditional monetary policy precedence, the Federal Reserve responded by buying government bonds, pumping liquidity into the financial market, and expanding bank reserves.

Unconventional Monetary Policy

The Fed also did something that was not widely noticed at the time and even a decade later is almost never taken into account in the analysis of Fed policy: it started to pay interest on reserves in October 2008--in essence paying banks not to lend (Board of Governors 2008). By paying interest on reserves, the Fed converted the reserves of the banking system into interest-bearing securities and a liability of the Fed. But in paying interest particularly on excess reserves, the Fed was able to inject massive liquidity into the financial system and expand bank reserves without significantly expanding the money supply (Gramm and Saving 2019).

Though the recession ended in the summer of 2009, six months after the Obama administration took office, the economic recovery that followed lagged further and further behind historic norms for postwar America. In an effort to stimulate the economy, the Fed used its large-scale asset purchase (LSAP) program (also known as quantitative easing or QE) to acquire federal debt and MBSs. Consequently, the Fed's asset holdings swelled to almost five times their prerecession levels. In so doing, the Fed acquired directly or offset some 45 percent of all federal debt issued during the Obama era, almost four times the share of federal debt the Fed purchased during World War II. (1) However, unlike Fed purchases during World War II--which produced an increase in bank reserves, bank lending, and the money supply--the much larger debt purchases of the Obama era did not significantly increase bank lending and the money supply. The increase in bank reserves, which grew as a mirror image of Fed asset purchases, were effectively sterilized by the payment of interest on reserves, inducing banks to hold the excess reserves as an income-yielding asset.

The need to sterilize such excess bank reserves was explained by Chris Phelan (2015) of the Minneapolis Federal Reserve:

For every dollar in excess reserves, a bank can lend 10 dollars to businesses or households and still meet its required reserve ratio.... Thus, if every dollar of excess reserves were converted into new loans at a ratio of 10 to one, the $2.4 trillion in excess reserves would become $24 trillion in new loans, and M2 liquidity would rise from $12 trillion to $36 trillion, a tripling of M2. Today's $1.75 trillion of excess reserves if fully loaned by the banking system, would by Phelan's analysis produce an inflationary 122 percent increase in the money supply. (2)

In August 2008, prior to the financial crisis, banks held $0.14 of reserves for every dollar of demand deposits outstanding, reflecting a normal reserve ratio in a fractional-reserve banking system. By 2011, with the interest rate paid on excess reserves 15 basis points above the interest rate on 1-year Treasuries, banks held some $2.90 of reserves for every dollar of demand deposits outstanding--over 20 times the precrisis level. Thus, banks were strongly incentivized to hold historic levels of excess reserves as the Fed expanded its assets by purchasing government bonds and MBSs. Even today, as the assets held by the Fed have begun to shrink and demand deposits have grown, banks still hold $1.31 of reserves for every dollar of demand deposits outstanding. As the Fed has sold assets and reduced bank reserves, it has incentivized banks to further reduce excess reserves by paying an interest rate on excess reserves 45 basis points below the interest rate on 1-year Treasuries.

Monetary Headwinds

Extraordinarily, today we do not have a fractional reserve banking system. In a term used by Irving Fisher, the 19th and 20th century economist who advocated eliminating fractional reserve banking, we have today in his words, "100% money" (Fisher 1936). The only period in American history with policies remotely similar to today's policy was during the Civil War after the passage of the National Banking Act of 1863. The National Banking Act of 1863 levied a 10 percent tax on state bank notes, driving them from circulation. It also granted national bank charters and allowed national banks to issue notes, provided they held government bonds dollar for dollar against their notes. In this way, the federal government created a massive market for its bonds, allowing the Treasury to fund part of the Civil War without driving up borrowing costs or printing additional "Greenbacks" and increasing inflation.

In the last decade, by comparison to the Civil War era, the Fed has purchased government bonds and other assets, which it has paid for by printing new money and inflating bank reserves. The Fed then paid banks interest to hold those excess reserves. Under the National Banking Act, commercial banks held the government bonds and were paid with interest on the bonds and given the ability to issue currency. Today the Fed holds the bonds and borrows from commercial banks to pay for them.

As a result of its quantitative easing programs, the Fed now holds 17 percent of the value of all publicly held federal debt and 27 percent of the value of all outstanding government-guaranteed MBSs. (3) While the initial injection of liquidity into the economy in 2008 clearly helped stabilize financial markets and was a classic central-bank response to a financial crisis, the subsequent monetary easing programs of the Obama era were unprecedented. After the recovery began, further monetary easing did little to strengthen the economy, but at least in part due to monetary easing, the Obama administration was able to double the federal debt held by the public while reducing the cost of servicing that debt below the interest costs that had been incurred when the debt was only half as large.

From 2009 to 2016, private loan demand was weak in an economy kept in a stupor by high taxes and an avalanche of regulations. In that stagnant environment, the Fed was able to manage a massive balance sheet and inflated bank reserves without either igniting inflation or causing interest rates to rise. However, the Fed's challenge is now growing enormously as the economy returns to normal growth. The strong growth of the last 18 months is driving up the demand for bank loans, increasing interest rates, and inducing banks to lend excess reserves. In addition, "Operation Twist" (by shortening the average maturity date of the debt held outside the Fed) will force the Treasury to borrow more money as the economy strengthens and interest rates rise.

Challenges Facing the Fed

Despite repeated assurances from the Fed that it has the ability to gradually raise interest rates at a pace of its own choosing and keep inflation rates in the 2 percent range, the reality is that, with banks holding unprecedented levels of excess reserves, the money supply is now primarily market driven. A rise in loan demand and market interest rates will incentivize banks to reduce excess reserves and expand loans, causing the money supply to increase. To prevent that from happening, the Fed will have to raise the interest rate it pays on excess reserves or sell bonds to reduce bank reserves as market rates rise.

Historically, when the Fed did not pay interest on excess reserves, banks held few excess reserves. When the public's preference for holding money relative to GDP was stable, the Fed controlled the money supply by controlling the volume of coin, currency, and bank reserves. With banks now holding more than $9.15 of reserves for every dollar they are required to hold, it is the return on bank lending relative to the return the Fed pays on excess reserves that determines the volume of excess reserves banks choose to hold, the volume of loans, and the money supply. (4)

The Fed now sets not just the fed funds target range; it sets the rate of interest that it pays on all reserves at the same time. That rate has a direct effect on monetary policy. When the Fed first began to pay interest on reserves, it also began setting the Fed funds rate as an upper and lower boundary, with the interest rate on reserves set as the upper limit for the fed funds target range. However, that changed in June 2017 when the interest rate paid on reserves was set 5 basis points below the upper limit target for the fed funds rate (Board of Governors 2017).

The policy effect embodied in setting the interest rate paid on excess reserves is that, if the rate is set above the market alternative for banks, they will expand their holding of excess reserves and the money supply will fall. If the interest rate on excess reserves is set at the market rate, other things being the same, the money supply will remain unchanged. Finally, if market interest rates rise and the rate paid by the Fed on bank reserves stays the same or rises by less, banks will expand loans and the money supply will rise. Before the Fed started paying interest on reserves, the money supply changed only when the Fed acted. Now if market interest rates rise and the Fed does not raise the rate it pays on excess reserves or take other actions to reduce bank reserves, the money supply rises. As a...