The Federal Reserve could pay more than $77 billion a year in interest on the excess cash reserves it holds for commercial banks if rates follow the highest path forecast by Fed policy makers.
The CHART OF THE DAY shows the Fed’s annual interest costs by the end of 2015 could range from $4.3 billion to $77.7 billion, depending on interest rates and assuming excess reserves remain at current levels, according to Bloomberg calculations based on Fed data. The central bank already has paid more than $13 billion since 2008 when Congress authorized interest on reserve balances as part of financial-rescue legislation.
The rate is currently 25 basis points, or 0.25 percent. When the time comes to tighten monetary policy, the Fed intends to raise it, which would boost interest rates throughout the financial system. The amount the central bank pays on excess reserves will increase at the same time borrowing costs for the U.S. Treasury are rising, a move that could prove unpopular in Congress, said Stephen Stanley, the chief economist for Pierpont Securities LLC in Stamford, Connecticut.
“The budget implications of the normalization of Fed policy are going to be immense,” Stanley said. “Having to pay billions and maybe tens of billions on excess reserves is one element of the broader issue that the Fed won’t always be having a positive impact on the federal budget.”
Paying higher interest on reserves also may squeeze the budget of the central bank itself. The Fed earns interest income on its bond holdings and, after covering its operating expenses, returns the profit to the U.S. Treasury. Last year, the Fed remitted $88.4 billion. As the interest payments on reserves rise, this profit could shrink or disappear.
Fed officials have begun to debate the political risk of their policy.
“The exit strategy as it currently stands has us paying interest on reserves to the largest banks in America exactly at the time when we are not remitting anything to the U.S. Treasury,” James Bullard, president of the St. Louis Federal Reserve Bank, said in a February interview with Bloomberg News. “The appearance issue is a serious one.”
In the five years before the crisis, excess bank reserves averaged $1.7 billion; the total now is $1.7 trillion because the Fed has created reserves to fund its large-scale asset- purchase programs, known as quantitative easing.
Those programs have pushed the central bank’s balance sheet to a record $3.2 trillion. Economists in a March 13-18 Bloomberg survey predicted it will grow to about $4 trillion by Dec. 31, before QE ends. That would push excess reserves to $2.5 trillion.
The ability to pay interest on reserves equips the central bank with another tool to tighten monetary policy when the time comes for it to unwind its unprecedented stimulus.
Last year, Fed officials began forecasting when they will raise the target on the benchmark federal funds rate for overnight loans between banks, which they cut to near zero in December 2008. Eighteen of 19 policy makers expect the target rate will remain at its current level through the end of this year, according to the most recent forecast.
By the end of 2014, 14 of 19 policy makers still see the target rate at zero, while five see it rising, with the highest estimate calling for a 4.5 percent target. That rate would bring the Fed’s annual interest costs to $77.7 billion by the end of 2015, assuming excess reserves remain at today’s levels. If the Fed were to create additional excess reserves by continuing QE3 asset purchases for the rest of this year, 2015 interest costs could rise as high as $112.5 billion at a 4.5 percent rate, according to Bloomberg calculations.
The size of payments the Fed has already made is generating criticism.
“Essentially the Fed paid the banks $4 billion last year, which is about $12 per American,” David Howden, a professor of economics at Saint Louis University’s campus in Madrid, Spain, said in an e-mail.
Howden analyzed interest on reserve payments so far for the Ludwig von Mises Institute, named for an Austrian free-market economist and philosopher.
“If your bank called you up and said you have a new service fee of $12 because they screwed up in the crisis, you’d be livid, but that is basically what they are doing and no one knows about it.”
William C. Dudley, president of the New York Fed, has said interest payments on excess reserves are “not a subsidy to the banks.”
“I look forward to the day when the economy is strong enough for us to raise the interest rate on excess reserves,” and “when that happens deposit rates will also rise,” Dudley said in a speech last month in New York. “It will be my mother and my mother-in-law and others like them, not bankers, who will mainly benefit.”
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