The Trojan Horse in the Gates of US Monetary Policy

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The Federal Reserve is embarked upon increasing the interest rate that they set on reserves held at the Fed. This is the interest rate that the Fed determines by diktat, coming after interest was allowed to be paid on reserves for the first time in 2008. This is being done to combat inflation.

Consider how interest rates are normally determined in free markets. They build in the amount of inflation to give a positive return to the dollar investment. That means that free market determination of interest rates will always equal whatever the inflation rate happens to be, or is expected to be, plus a positive return to the saver offering the funds for investment. Interest rates equal the sum of the inflation rate plus the equilibrium market return to the capital being lent.

Before 2008, the Federal Reserve set interest rates by how much Treasury debt that the Fed bought. If the Fed buys more Treasury debt, the money supply reserves at banks are increased as the banks sell the Treasury debt to the Fed in secondary Treasury debt markets. Before 2008, banks would lend out all but the required reserves, keeping just a small fraction of their new reserves still held at the Fed. The rest of the reserves would then enter circulation as the money was lent out for new investment.

Before 2008, free markets and the Fed worked hand-in-hand by determining interest rates according to how much Treasury debt that the Fed would buy. When the Fed increased its rate of purchasing Treasury debt and the growth of new reserves rose at an accelerated rate, then market interest rates would be driven down as the new reserves enter circulation and increase the supply of capital in capital markets. This lowers interest rates in the short term due an increase in liquidity in capital markets.

An abrupt change in Fed policy took place in 2008. Rather than letting market interest rates be determined freely in markets, the Fed used an esoteric law – The Financial Services Regulatory Relief Act of 2006 – to pay interest on all reserves held at the Fed. This Act was intended to pay interest only on the 1% of all commercial bank deposits held as required reserves, not on any amount of reserves. The Act’s legislative history is clear that it was aimed at helping smaller banks that had a larger percent of required reserves that did not earn interest, than did larger banks, thus providing “regulatory relief” to smaller banks. However, the Act’s exact wording is that it allows the Fed to pay “interest on reserves.” The Fed ignored the intent of the law, effectively lobbied to move its effective date up to 2008 instead of 2011, and began paying interest on all reserves instead of only on required reserves.

Paying interest on reserves created a Trojan horse whereby the Fed could set interest rates on the most important source of international financial liquidity – US Treasury short term debt – by dikdat. This is because the interest paid on reserves has set in tandem the US Treasury debt interest rates as well, even if this was “unintended.” 

The Fed paying this interest on reserves caused reserves to build up so that the new money supply has effectively sterilized in part by inducing it to remain in the Fed’s coffers. Thus began the disconnects that exist to this day. The amount of the Treasury debt that the Fed purchases does not automatically enter circulation since banks can sell their Treasury debt to the Fed, get credited for the sales as new reserves, and then still earn interest on all reserves. This is despite that fact that banks sold their right to earn the interest stream on the Treasury debt by selling it to the Fed. This created the first disconnect: the money supply increase no longer automatically goes into circulation ever since banks began building up excess reserves at the Fed. The 2020-2022 surge in Fed-bought Treasury debt and in the reserves held at the Fed caused our new episode of inflation, similar to that of the 1970s and early 1980s. This inflation results since so much money was printed that it escaped from reserves into circulation at a high rate. The money supply that entered circulation at an accelerated rate caused the acceleration in inflation, unlike directly after 2008 when almost all new money was held as reserves at the Fed, right up until 2014.

The second disconnect is that market interest rates became set by the Fed. When the Fed set the interest on reserves at a quarter of one percent for seven years from the end of 2008 until the end of 2015, the fungibility of capital meant that the Treasury short term interest rates were all below or equal to the Fed’s arbitrary setting of what interest rate to pay on reserves. This meant the Fed was setting interest rates by diktat rather than by the amount of money it was creating by buying Treasury debt.

The Fed was setting interest rates below the normal market rate that would include at least the inflation rate and has been ever since 2008, with only eleven months of a positive real return in 2018-2019. This is like how the Soviet Union set the price of bread in markets below the competitive equilibrium price in order to subsidize the price. The problem when the Fed does it is that it causes the international financial system to seek a higher yield by buying up what is viewed as the next best low-risk, high yield asset. Since the mortgage-backed securities crash, this has led to all types of diverse and increased risk-taking by the financial system to offset negative yields on Treasury debt.

The payment of interest on all reserves is equivalent to an allocation that should be approved by the Congressional Budget Reconciliation process each year. The same goes for the Fed’s continued purchase of mortgage-backed securities that is illegal under the Federal Credit Reform Act of 1990 that requires all loan purchases to be approved in the Congressional budget process. The Fed buying mortgages is a misdemeanor compared to the felony of paying interest on reserves, which sets interest rates by diktat below free market rates, induces greater international financial fragility through increased risk-taking, and allows into the gates of finance the Trojan horse of direct government takeover of interest rate setting. The free market determination of rates was thus vanquished in 2008. That practice can be ended in a single day, by the Fed setting the interest rate on reserves at zero.

Max Gillman is the Hayek Professor of Economic History at the University of Missouri – St. Louis and author of forthcoming book The Spectre of Price Inflation.

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