There has been much discussion about the large increase in reserves, and especially excess reserves, held by the nation’s banking system. Mostly this discussion is couched in terms of the increase in the money supply. But although the increase in excess reserves—rising from less than $2 billion in August 2008 to almost $1.5 trillion at the end of 2012—does represent an increase in the money supply, some rule changes accompanying the crisis also signify they are part of a bailout.
One aspect of the Fed’s crisis response was to begin paying interest on required and excess reserve balances. (The required reserve is the amount of money banks must hold to meet the minimum reserve requirement on deposits, and excess reserves are any amount held in excess of this minimum.)
Interest on reserves is set at 0.25 percent, and it is paid from the Fed’s operating revenues to its member banks. The Fed has paid the banking system nearly $4 billion each year for the last two years to hold on to their reserves.
A Form of Bailout
One way to think of this payment is as a sort of bailout. Since the payments on reserves come from the Fed’s operating revenues, it reduces its end of year profits by the same amount. Since these profits would normally be remitted to the Treasury, the interest on reserves has been, in effect, a fiscal policy involving a transfer from the Treasury to the banking sector.
Interest on reserves redirects taxpayer money to the banking system, more than $4 billion during 2012. This transfer from the Fed to the banking system is larger than any single year transfer from the Fed to the Treasury prior to 2009.
The Fed estimates it will remit to the Treasury $88.9 billion from its 2012 operations, a record-setting year.
The sharp increase after 2008 was the result of the quantitative easing policies. By increasing the money supply, the Fed had to purchase assets from the banking system. These assets included U.S. Treasuries, riskier mortgage-backed securities, and guaranteed Federal agency debt. All of these newly purchased assets paid interest, which contributed to the increase in Fed operating revenues and profits as it increased the money supply.
The $91 billion of net income came almost wholly from interest earned on the securities the Fed holds.
The U.S. Treasury issues bonds which are bought by the Federal Reserve. (We should note that the Fed doesn’t buy these bonds directly from the Treasury, but only on the secondary market from favored dealers.) Interest paid on these bonds accumulates at the Fed as income, and at the end of the year the Fed distributes it back to the Treasury, less its operating expenses. Since the Fed held, give or take, about $1.6 trillion of U.S. Treasury securities over 2012, the government was essentially able to get a free lunch—any interest paid on these securities was an accounting fiction, as it was remitted back at the end of the year (less expenses).
Normally the Fed operates only at the short end of the yield curve. This means as a general rule the Fed purchases only short-term U.S. Treasury debt. Since short-term debt is also the lowest-yielding, some might say the Fed is not really providing much of a free lunch.
The big news during 2012 for Fed watchers was the expansion of its “Operation Twist.” With an increased focus on the long end of the yield curve, the Fed started purchasing bonds of longer maturity to keep long-term borrowing costs low. This was a savvy move that would help shield the Treasury from the effects of some of the Fed’s own policies.
Masked Inflation Premium
The Fed has the potential to increase inflationary pressures on prices through its monetary expansion. Since this inflation is not occurring now, but almost certainly will at some future date, only longer-dated securities will see their yields rise to account for their lost purchasing power. This would spell disaster for a Treasury that finances itself in part with longer-dated securities. By pledging to buy longer-term bonds, the Fed will artificially reduce their yields and thus mask the inflation premium building on their yields.
Although the Fed has slightly decreased the total amount of Treasuries held, Operation Twist has increased the average maturity of these holdings. The Fed currently holds almost no Treasuries with maturities under one year and has increased its holdings dated longer than five years by more than $200 billion. Thus although the total amount of Treasury debt held has decreased, the total distribution to the Treasury has increased because of this maturity shift. By holding higher interest rate bonds of longer maturities, the Fed earns more interest, which results in more profit to remit to the Treasury at year-end.
As we review the Fed’s operations in 2012 we see the usual outcomes. The banking sector has benefited from its operations (unusually so, thanks to the continued interest on reserve policy) and the government has received a free lunch by having a ready buyer for its ever-increasing debt, especially long-term debt, which might otherwise be susceptible to inflationary pressures increasing its interest yield.
David Howden ([email protected]) is chairman of the Department of Business and Economics at Saint Louis University-Madrid. Reprinted with permission of Mises.org, where an earlier version of this article appeared.