The Fed Created An Inflation Bomb. The Taxpayers Are Now Footing The Bill.
On the Fed’s irresponsible practices
Last month, I wrote about Federal Reserve Board Chair Janet Yellen’s visit before the House Financial Services Committee.
Before the House, Yellen faced grilling on a topic that hasn’t received enough mainstream attention: the interest being paid on excess reserves at the Fed. While the topic has come up occasionally since the program began in 2008, it is worth noting that Yellen was pushed by both Rep. Jeb Hensarling, the committee chairman, and Rep. Andy Barr, the chairman of the Monetary Policy subcommittee.
While ending this taxpayer subsidy to Wall Street is important, it’s also important to understand the dangers posed by allowing these excess reserves to be lent out of major financial institutions.
To understand what’s at stake, recall back to 2008 when many Fed observers were concerned about the inflation dangers posed by the policies of the Bernanke Fed. In a six year period, the base money supply increased more than four times over. Understandably, this sparked grave fears about the devaluation of the dollar — fears that, to date, have yet to really present themselves in the Consumer Price Index.
While stock prices, real estate prices, and other forms of asset-price inflation are likely being fueled by this monetary policy, the Fed isn’t facing political pressure from inflation concerns. Disappointingly, they’re merely being grilled by misinformed legislators for not reaching their (unfortunate) 2% inflation target.
This is, in part, due to the fact that a lot of this new money has been kept sterile by being parked within the Fed itself as excess reserves. Today, more than two trillion dollars’ worth of these reserves are parked at the Fed, which means that only two-thirds of the newly created money has actually been pumped into the “real economy.”
Now this policy should rightfully puncture the narrative that the Fed was at all concerned with providing liquidity to businesses on Main Street (i.e., not big banks). After all, if the aim of the various rounds of quantitative easing was to get banks to loan, then paying them not to is irrational. Instead, the Fed was using taxpayer dollars to subsidize the very same banks they just bailed out. We are continuing, to this day, to pay banks to not make loans.
While Bernanke repeatedly dismissed the problem of incentives posed by paying 25 basis points on these reserves, the reality is that this was a risk-free investment at a time of great market volatility. Considering that several important banks had issues passing the Fed’s stress tests — tests are designed to exaggerate the stability of the financial sector — it doesn’t require a great logical leap to suggest that the Fed misrepresented this program to public in the name of “stabilizing” the financial sector.
In 2016, this policy paid $16 billion to big banks, a number that will likely rise as the interest rate payments go up with every increase in the federal funds rate. We are now paying 1.25 percent interest, higher than the public can receive from their own banks.
While both the public and Fed critics on Capitol Hill should be outraged at this clear example of cronyism, simply ending it is not enough. After all, the danger of refusing to pay ransom money is that the ransomer will follow through on their threat. If the Fed was to simply stop payment on these funds, and banks decided to lend it out, then two trillion dollars would be injected into credit markets. Given the amplifying effects of a fractional reserve banking system, it’s easy to see how quickly this could unleash severe inflationary pressures.
So this is the true policy issue going forward: How do you stop the taxpayer subsidy to Wall Street while avoiding lighting the fuse to Bernanke’s inflation bomb?
A promising solution would involve increasing reserve requirements. Currently, banks with over $115.1 million in liabilities have to keep 10 percent at the Fed. Raising that number will not only serve to keep this expansion of the monetary base “sterile,” but will make the banking sector as a whole more stable.
