Last week, Fed Chairman Jerome Powell delivered his semiannual monetary policy report to Congress. Fed watchers will find lots to chew on, but the really interesting material comes in his responses to legislators’ questions. In particular, Powell’s statements about the Fed’s role in credit allocation deserve a closer look.
Senator Mike Rounds (R-S.D.) asked the Fed chairman about shrinking the Fed’s massive (~$6.6 trillion) balance sheet. This would move the Fed back from an abundant reserves system to a scarce reserves system. Chairman Powell responded that the abundant reserves system was:
…a result of the global financial crisis and the desire to have lots and lots of liquidity and large liquidity requirements, for our largest banks in particular. So that’s a good thing. And that enables banks to keep lending through stress and that kind of thing. If you were to want to go back to scarce reserves, it would be a long and bumpy and volatile road. I wouldn’t recommend that we undertake that road. It would not save any money. There’s an illusion that it would save money. That is not the case. And it would also not make credit more available. This, you know, in effect—I would say having a lot of liquidity in the system, which is what goes with ample reserves, makes sure that banks will be able to continue to lend. So, we think it works. And I think unwinding it is a policy choice which could be executed, but it would take years to execute and it would be challenging and quite volatile.
In brief, Powell thinks the switch from scarce to abundant reserves was justified by credit conditions. This is a strange claim by the chairman. The distinguishing feature of an abundant reserves system is not expanding credit. Instead, it’s allocating credit. Fed officials have much more power to pick winners and losers under the post-Great Financial Crisis framework. That Powell won’t acknowledge legislators’ concerns with this system is worrying.
Let’s start with the basics. Prior to the Great Financial Crisis, the Fed operated within a scarce reserves system. Since the federal funds rate was generally between the discount rate and the interest the Fed paid on reserve balances (which was zero before October 2008), changes in the supply of or demand for bank reserves caused the federal funds rate to rise or fall. The Fed’s job was to manage liquidity in the banking system through open market operations. Increasing the supply of reserves decreased the federal funds rate; decreasing the supply of reserves increased it.
The Fed’s ability to expand its balance sheet under a scarce reserves system without creating inflation is limited. Banks would lend out new reserves, pushing up the money supply and total spending on goods and services (aggregate demand). Output may temporarily expand in the short run if businesses are fooled into producing for dollars that are not worth as much as they think. But sooner or later, they will spot the easy money and return to normal production. The resulting dollar depreciation, in contrast, is definite and permanent.
Things are very different in an abundant reserves system, where the federal funds rate is at or below the interest rate the Fed pays on reserves. In this system, further increases in the supply of reserves do not affect the federal funds rate. Instead, the Fed hits its interest rate target by altering the interest it pays banks to hold reserves. This is an administered rate, unlike the market-determined federal funds rate. Administrative fiat, rather than market forces, takes the lead.
An abundant reserves system makes it much easier for the Fed to steer credit to preferred counterparties without causing inflation. Suppose the Fed wants to support a specific asset price, such as mortgage-backed securities. The Fed credits its counterparty with bank reserves and puts the MBS on its own books. It then pays a sufficiently high rate on those reserves to ensure they are not lent and spent. If the Fed’s counterparties do not lend against the additional reserves in their accounts at the Fed, neither the money supply nor aggregate demand rise. And, if there’s no additional spending, inflation remains muted, too. All we get is a balance sheet effect: the private firms that sold MBS to the Fed now have a much safer and more liquid asset (bank reserves) on their balance sheet than the questionable security (MBS) they previously held. And, in the broader market, MBS prices rise, too.
This is what makes the abundant reserves system attractive to monetary technocrats: it allows them to meddle with relative prices, and hence direct funds to specific borrowers or sectors, without the spillover effects on inflation. Any institution the Fed deems “systemically important” can now get an injection of reserves without the accompanying headache of price level instability. In short, the abundant reserves system allows the Fed to put its thumb on the scale, allocating credit as it sees fit.
From this, we can see that Chairman Powell’s other claims (about helping taxpayers and fostering liquidity) are also unfounded.
To prevent new bank reserves from driving up the money supply and total spending, the Fed has to pay banks to keep new liquidity parked in Fed accounts. That’s a cost for the Fed that, all else equal, lowers its profits. Thus, Treasury remittances, which come from Fed profits, fall as well. Of course, all else may not be equal. In particular, the Fed’s profits may remain constant or rise if it holds a riskier portfolio, implicitly on the Treasury’s behalf. Either way (via reduced remittances or additional risk), taxpayers bear the cost of the abundant reserves system.
Nor does an abundant reserves system make it easier for banks to lend. The whole point of the abundant reserves system is to prevent banks from lending. If banks lent against reserves as they did before October 2008, Fed asset purchases would spark inflation. The Fed wants to bolster asset prices without the downstream inflationary consequences that would occur in a scarce reserves system. The abundant reserves system is not about promoting general macroeconomic stability. It’s about targeting specific institutions and assets based on central bankers’ judgment. The Fed is engaging in credit allocation, not broad-based monetary policy.
Chairman Powell’s testimony is best explained by his desire to protect the independence of his institution. It’s what any central banker would do. If Powell admitted the Fed is allocating credit, Congress might restrict its powers. But what’s good for the Fed is not necessarily good for the American people. In fact, there’s a serious case that the Fed has become a self-licking ice cream cone. Wall Street benefits from Fed credit policies, but it’s Main Street that pays.
Powell’s comments suggest we need more Congressional involvement in Fed governance and oversight, not less. Monetary policy will remain unconstrained by the rule of law until legislators exercise their constitutional authority to discipline the Fed’s perpetual self-promotion.