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INTEREST ON RESERVES AND 

THE FED’S BALANCE SHEET 

HEARING 

BEFORE THE

SUBCOMMITTEE ON MONETARY 

POLICY AND TRADE 

OF THE

COMMITTEE ON FINANCIAL SERVICES 

U.S. HOUSE OF REPRESENTATIVES 

ONE HUNDRED FOURTEENTH CONGRESS 

SECOND SESSION 

MAY 17, 2016 

Printed for the use of the Committee on Financial Services 

Serial No. 114–87 

( 

(II) 

HOUSE COMMITTEE ON FINANCIAL SERVICES 

JEB HENSARLING, Texas, Chairman 

PATRICK T. MCHENRY, North Carolina, 

Vice Chairman 

PETER T. KING, New York 

EDWARD R. ROYCE, California 

FRANK D. LUCAS, Oklahoma 

SCOTT GARRETT, New Jersey 

RANDY NEUGEBAUER, Texas 

STEVAN PEARCE, New Mexico 

BILL POSEY, Florida 

MICHAEL G. FITZPATRICK, Pennsylvania 

LYNN A. WESTMORELAND, Georgia 

BLAINE LUETKEMEYER, Missouri 

BILL HUIZENGA, Michigan 

SEAN P. DUFFY, Wisconsin 

ROBERT HURT, Virginia 

STEVE STIVERS, Ohio 

STEPHEN LEE FINCHER, Tennessee 

MARLIN A. STUTZMAN, Indiana 

MICK MULVANEY, South Carolina 

RANDY HULTGREN, Illinois 

DENNIS A. ROSS, Florida 

ROBERT PITTENGER, North Carolina 

ANN WAGNER, Missouri 

ANDY BARR, Kentucky 

KEITH J. ROTHFUS, Pennsylvania 

LUKE MESSER, Indiana 

DAVID SCHWEIKERT, Arizona 

FRANK GUINTA, New Hampshire 

SCOTT TIPTON, Colorado 

ROGER WILLIAMS, Texas 

BRUCE POLIQUIN, Maine 

MIA LOVE, Utah 

FRENCH HILL, Arkansas 

TOM EMMER, Minnesota 

MAXINE WATERS, California, Ranking 

Member 

CAROLYN B. MALONEY, New York 

NYDIA M. VELA ́ ZQUEZ, New York 

BRAD SHERMAN, California 

GREGORY W. MEEKS, New York 

MICHAEL E. CAPUANO, Massachusetts 

RUBE ́ N HINOJOSA, Texas 

WM. LACY CLAY, Missouri 

STEPHEN F. LYNCH, Massachusetts 

DAVID SCOTT, Georgia 

AL GREEN, Texas 

EMANUEL CLEAVER, Missouri 

GWEN MOORE, Wisconsin 

KEITH ELLISON, Minnesota 

ED PERLMUTTER, Colorado 

JAMES A. HIMES, Connecticut 

JOHN C. CARNEY, JR., Delaware 

TERRI A. SEWELL, Alabama 

BILL FOSTER, Illinois 

DANIEL T. KILDEE, Michigan 

PATRICK MURPHY, Florida 

JOHN K. DELANEY, Maryland 

KYRSTEN SINEMA, Arizona 

JOYCE BEATTY, Ohio 

DENNY HECK, Washington 

JUAN VARGAS, California 

SHANNON MCGAHN, Staff Director 

JAMES H. CLINGER, Chief Counsel 

(III) 

SUBCOMMITTEE ON MONETARY POLICY AND TRADE

BILL HUIZENGA, Michigan, Chairman 

MICK MULVANEY, South Carolina, Vice 

Chairman 

FRANK D. LUCAS, Oklahoma 

STEVAN PEARCE, New Mexico 

LYNN A. WESTMORELAND, Georgia 

MARLIN A. STUTZMAN, Indiana 

ROBERT PITTENGER, North Carolina 

LUKE MESSER, Indiana 

DAVID SCHWEIKERT, Arizona 

FRANK GUINTA, New Hampshire 

MIA LOVE, Utah 

TOM EMMER, Minnesota 

GWEN MOORE, Wisconsin, Ranking Member 

BILL FOSTER, Illinois 

ED PERLMUTTER, Colorado 

JAMES A. HIMES, Connecticut 

JOHN C. CARNEY, JR., Delaware 

TERRI A. SEWELL, Alabama 

PATRICK MURPHY, Florida 

DANIEL T. KILDEE, Michigan 

DENNY HECK, Washington 

(V) 

C O N T E N T S 

Page 

Hearing held on: 

May 17, 2016 ..................................................................................................... 1 

Appendix: 

May 17, 2016 ..................................................................................................... 41 

WITNESSES 

TUESDAY, MAY 17, 2016 

Eisenbeis, Robert A., Vice Chairman, Cumberland Advisors .............................. 5 

Keister, Todd, Professor of Economics, Rutgers University ................................. 7 

Selgin, George, Director, Center for Monetary and Financial Alternatives, 

Cato Institute ....................................................................................................... 9 

Taylor, John B., Mary and Robert Raymond Professor of Economics at Stanford University ..................................................................................................... 11 

APPENDIX 

Prepared statements: 

Waters, Hon. Maxine ........................................................................................ 42 

Eisenbeis, Robert A. ......................................................................................... 47 

Keister, Todd ..................................................................................................... 59 

Selgin, George ................................................................................................... 67 

Taylor, John B. ................................................................................................. 83 

ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD

Huizenga, Hon. Bill: 

Written statement of David Malpass .............................................................. 90 

(1) 

INTEREST ON RESERVES AND 

THE FED’S BALANCE SHEET 

Tuesday, May 17, 2016 

U.S. HOUSE OF REPRESENTATIVES, 

SUBCOMMITTEE ON MONETARY

POLICY AND TRADE, 

COMMITTEE ON FINANCIAL SERVICES, 

Washington, D.C. 

The subcommittee met, pursuant to notice, at 10:03 a.m., in room 

2128, Rayburn House Office Building, Hon. Bill Huizenga [chairman of the subcommittee] presiding. 

Members present: Representatives Huizenga, Mulvaney, Pearce, 

Stutzman, Pittenger, Messer, Schweikert, Guinta, Love, Emmer; 

Moore, Foster, Himes, Murphy, Kildee, and Heck. 

Ex officio present: Representatives Hensarling and Waters. 

Chairman HUIZENGA. The Subcommittee on Monetary Policy and 

Trade will come to order. Without objection, the Chair is authorized to declare a recess of the subcommittee at any time. 

Today’s hearing is entitled, ‘‘Interest on Reserves and the Fed’s 

Balance Sheet.’’ 

I now recognize myself for 5 minutes to give an opening statement. 

So how did the Fed receive authorization to pay interest on reserves? At what level was it supposed to have set that interest 

rate? 

And most importantly, how is this new and powerful tool for conducting monetary policy affecting our economy, which continues to 

disappoint after having 7 years to recover? 

We will hear some of the answers to these questions and many 

others during today’s important hearing. And I feel I need to address something that came to my attention a little earlier this 

morning. 

Apparently, there are some folks on Wall Street who have sent 

out some alerts using that term themselves about this hearing, 

that somehow interest on reserves is under attack. 

To the fine folks up on Wall Street, you are on notice. We are 

going to have a thorough complete examination of what it is. I 

think there is a tremendous amount of questions that surround it. 

In fact, in February when Chair Yellen was here testifying in 

front of the full Financial Services Committee, there were a number of concerns expressed on both sides of the aisle. 

In fact, as I recall, Chairman Hensarling allowed the ranking 

member to go long, as she was asking a line of questioning about 

2 

that. And so there are quite a few questions on both sides of the 

aisle about it. 

And as we are looking at foreign subsidiaries and large banks 

being the recipients of the lion’s share of this, that has a number 

of people very concerned of how that may also affect our small community banks and our regional banks and the liquidity in the marketplace. 

So there are a tremendous number of questions that are out 

there, and we intend on this subcommittee to explore those. 

The Financial Services Regulatory Relief Act of 2006 authorized 

the Federal Reserve Board to start paying interest on reserves in 

2011. 

In response to the financial crisis, the Emergency Economic Stabilization Act accelerated this authority to October 1, 2008. According to the New York District Bank, the Fed expected to set interest 

rates, interest on reserves well below the Fed’s target policy rate, 

that is, the Federal Funds rate. 

Had the Fed created such a ‘‘rate floor,’’ it would have complied 

with the letter of the law, Section 201 of the Financial Services 

Regulatory Relief Act of 2006, which explicitly states that interest 

on reserves ‘‘cannot exceed the general level of short-term interest 

rates.’’ 

As we sit here today, however, interest on reserves is above the 

Federal Funds rate. This above-market rate not only appears to 

have gone outside the bounds of the authorizing statute, it also 

may be discouraging the more free flow of credit to an economy 

that can and should be flourishing. 

Speeding up the authority to pay interest on reserves equips the 

Fed to expand its balance sheet to previously unimaginable heights 

and broaden its remit to, as University of California economist 

James Hamilton put it, ‘‘the decision of where credit gets allocated.’’ 

Responding to the immediate financial crisis, the balance sheet 

more than doubled to almost $2 trillion. Subsequently, various 

rounds of quantitative easing saw the balance sheet more than 

double again. 

Today, the Fed’s balance sheet stands at $4.5 trillion. That is 

about 25 percent of the total GDP of the United States. And as I 

say to folks back home, sometimes we lose perspective on how 

many zeros are in a trillion. 

And I always tell them, write a one and 12 zeros behind it and 

start counting backwards to where it is a thousand, ten thousand, 

a hundred thousand, and you see how big those numbers really 

are. 

At the same time, the average maturity of Treasury securities 

held by the Fed increased from about 5 years to over 10 years, 

which considerably increases the balance sheet’s exposure to interest rate duration risk. 

Almost 7 years old, the Fed’s colossal and distortionary balance 

sheet shows no signs of shrinking. To be sure, the Fed appears to 

have only started thinking about an exit as described in its late 

2014 Policy Normalization Principles and Plans report, but the 

word ‘‘principles’’ is nowhere to be found in this description. 

3 

Moreover, the plan simply mimics the same opaque ‘‘data-dependent strategy’’ for monetary policy that has left market participants scratching their heads for years wondering what data will inform the Fed’s decision-making and how will the FOMC react to 

that data. 

We will not fully realize robust economic growth until the Fed returns to a rules-based strategy for reliable supporting of the free 

flow of goods and services with an efficient exchange mechanism, 

in my opinion. 

As former Federal Reserve Board Governor Kevin Warsh observed, ‘‘Currency stability is one of growth’s best friends.’’ Unfortunately, monetary policy has clearly stepped outside this bound 

and shows little, if any, sign of returning. 

This lack of a clear and prudent strategy not only puts present 

economic opportunity at risk, it threatens the durability of monetary policy independence itself. 

Today’s hearing provides us with another opportunity to examine 

how the Federal Reserve conducts monetary policy and why the development of these policies is in desperate need of a more disciplined and transparent approach. 

Needless to say, the Fed’s high degree of discretion and its lack 

of transparency in how it conducts monetary policy continue to suggest that reforms are needed. 

My time has expired. The Chair now recognizes the ranking 

member of the subcommittee, the gentlelady from Wisconsin, Ms. 

Moore, for 5 minutes for an opening statement. 

Ms. MOORE. Thank you so much, Mr. Chairman. And I want to 

welcome the witnesses. I think everyone seems to agree that the 

current situation is our rational and predictable way for the Fed 

to raise interest rates, which is what they have done. 

And that is primarily to pay interest on excess reserves. I agree 

with it, but I certainly can understand why perhaps Dr. Taylor 

here and others may disagree with why or how the Fed got here. 

But for those who understand the Fed’s use of the IOER and to 

a lesser extent, the reverse repo markets, this is the best way for 

increasing interest rates, because we have to return some sort of 

normalization. 

We just can’t have close to zero interest rates. Congress voted to 

provide the Fed with the ability to pay interest on excess reserves 

in 2006 when it passed H.R. 3505, a bill sponsored by our Chairman Hensarling. 

Many of us voted for this bill, myself included. So we clearly and 

affirmatively authorized the Fed to take these actions. We know 

that this is not only a tool that our central bank, our Fed, used but 

that many other central banks are also currently employing. 

In other words, our Fed used the best tool for the job that is both 

well-established among central banks and authorized by our Congress. I do agree that it is horrible optics. 

It is a policy debate that is raging because there is a concern 

about subsidizing the banks. I do feel encouraged to know that the 

profits, whatever profits are received from the Fed actually go back 

to the Treasury. 

4 

So, it is horrible optics, but I don’t think in reality we are subsidizing the banks. This is a very complicated policy, so I definitely 

look forward to this hearing. 

And I know that is true for us in liberal Milwaukee, as well as 

conservative Michigan Heights, Michigan. I would like to yield the 

rest of my time to the ranking member of the full Financial Services Committee, Ms. Waters. 

Ms. WATERS. Thank you very much, Congresswoman Moore, but 

I would like to yield my time to Mr. Himes. 

Ms. MOORE. I will yield the time to Mr. Himes. 

Ms. WATERS. Thank you. 

Mr. HIMES. Thank you to the ranking member and to Ms. Moore 

for that. I am not entirely prepared for the time, but I do feel very 

strongly about this. And so thank you, I really appreciate the yielding of time. 

Look, the subjects don’t get a lot more complicated than interest 

paid on excess reserves, but there are two things that are pretty 

uncomplicated. And those two things are why I am here. 

Number one, there is a certain irony to the Congress of the 

United States holding the Fed up for scrutiny for their conduct of 

monetary policies since the crisis of 2008. 

With the exception of the American Recovery Act, which was profoundly controversial and partisan here, Congress has utterly and 

completely abnegated its role to conduct the kind of fiscal policy 

that classical economics and most economists would say we should 

have done. 

Yes, we passed the Recovery Act and that was about $800 billion 

of fiscal stimulus. Most economists today, those who are driven by 

empirical analysis, would tell you that was too little and too heavy 

on tax cuts and not heavy enough on infrastructure investment and 

the kind of things that actually put Americans back to work. 

Okay, so we had that fiscal stimulus. That was important. Since 

then, since 2009, the Congress has completely abdicated the role 

that economists across the political spectrum would say we should 

do, which is to continue with classic fiscal stimulus. 

So, in the context of the Congress completely abnegating its fiscal 

role, we have had no other game in town but for the monetary policy conducted by the Federal Reserve. 

And you know what, we highlight the word ‘‘innovative’’ around 

here, and we say we want them to be innovative. Yes, their policies 

with the Twist and with QE2 were innovative. 

They were different than the conduct of monetary policy, but because of the Federal Reserve’s policy, including the payment of interest on reserves we have what is without question the most robust recovery amongst industrialized OECD nations however you 

want to play it. 

And I have asked this question of Chairman Bernanke time and 

time again. Now this is a complicated thing, but we need to talk 

more about the fact that this is a transaction with two parts. 

Yes, we pay about $7 billion, or the Fed pays about $7 billion. 

Meanwhile, the Fed is returning about $100 billion to the United 

States Treasury. Those are the two halves of this transaction. 

And I do hope we have an opportunity to discuss that in this 

hearing. I thank the ranking member for the time and I yield back. 

5 

Chairman HUIZENGA. The gentlelady’s time has expired. And I 

imagine we will get into a few of those issues today with the testimony of our panel of experts we welcome today. 

First, we have Dr. Robert Eisenbeis, vice chairman of Cumberland Advisors 

Second, we have Dr. Todd Keister, professor of economics at Rutgers University. 

Third, we have Dr. George Selgin, director of the Center for Monetary Policy and Financial Alternatives at the Cato Institute. 

And last, but certainly not least, we have Dr. John B. Taylor, the 

Mary and Robert Raymond professor of economics at Stanford University. 

Each of you will be recognized for 5 minutes to give an oral presentation of your testimony, which we have received written copies 

of previously, and without objection, each of your written statements will be made a part of the record. 

And before I forget, Dr. David Malpass was supposed to be part 

of this panel today. Unfortunately, he had a death in the family, 

and we wish him and his family all the best. 

They are in our thoughts and prayers collectively. I would like 

to submit for the record, without objection, his written testimony 

as well, and would ask that we make that a part of the record. 

With that, Dr. Eisenbeis, you are recognized for 5 minutes. 

STATEMENT OF ROBERT A. EISENBEIS, VICE CHAIRMAN, 

CUMBERLAND ADVISORS 

Mr. EISENBEIS. Thank you very much. Chairman Huizenga, and 

Ranking Members Moore and Waters, I really appreciate the opportunity, and I am honored to be here today. 

I want to address in particular certain misconceptions about the 

Federal Reserve’s balance sheet and some of the fund flows that 

take place between the Fed and the Treasury and how that interplays with the interest on reserves. 

Often the Fed is compared to a private sector bank, but there are 

really some fundamental differences between the Fed and a private 

sector bank. 

The Fed is a government entity and when analyzing payment 

flows and fund flows and balance sheets, I think it is really best 

to look at the process and implications from the perspective of the 

consolidated governments balance sheet rather than separately the 

Federal Reserve and the Treasury. 

Unlike a private bank, to purchase assets, the Fed really doesn’t 

have to go into the marketplace and pay interest on funds in order 

to generate the resources to purchase government securities. 

When it purchases a security, essentially what it does is it increases the reserve account of the seller’s bank’s reserve account. 

And had it paid for Treasuries by drawing down its stock of Federal Reserve notes, we would have said the Fed had printed money 

and monetized Treasury debt. 

It is also important to understand that unlike deposits at a private sector bank, reserves never leave the Federal Reserve when 

one bank or one of its customers engages in a transaction. Ownership of a reserve account may change, but the funds never leave 

the Fed. 

6 

Now what about payment of interest on reserves? The Fed is 

paid interest by the Treasury on its portfolio holdings. It then extracts its operating costs, including interest payments on reserves 

and returns the remainder to the Treasury. 

From the perspective of the consolidated Fed/Treasury/Government balance sheet, the Fed purchases higher cost Treasury debt 

off the market and replaces it with another form of de facto Government short-term debt paying 50 basis points. 

If this intragovernmental transfer of funds between the Fed and 

the Treasury were settled the way interest rates swaps are settled 

by netting, there would always be a net payment, a transfer of 

funds from the Treasury to the Fed. 

Furthermore, Treasury securities are effectively retired because 

of the fact that the government owns its own debt. The Treasury 

is covering the Feds operating costs and effectively is making those 

interest payments on reserves. 

So it is a mistake to characterize Fed remittances, as is commonly done, as a return of profits made by the Fed to the Treasury. 

It is only due to a flaw in government accounting that the Treasury 

can count such remittances from the Fed as revenue for budget 

purposes. 

This is clearly a case of questionable accounting, and is misleading when it comes to the treatment of government revenues 

and resources. Our interest payments are subsidied to banks. This 

is a common question and concern. 

In the wake of the Great Recession, interest on reserves became 

an essential tool for the Fed to influence short-term interest rates. 

For most of history, the Federal Reserve had paid no interest on 

reserves at all. 

But requiring banks to hold a portion of their assets as noninterest-bearing reserves against their deposits effectively reduced 

bank earnings and functioned like a tax. 

Because this tax was high and especially during inflation periods 

like we had in the 1970’s and 1980’s, many banks opted to give up 

their membership in the Federal Reserve. 

And the Fed even resorted to providing free payment services to 

the equivalent of toasters, we saw in the private sector, to offset 

the ongoing cost of membership. 

Predictably, banks sought to minimize excess reserves by expanding loans, thus converting excess reserves into required reserves. For the banking system as a whole, this practice created a 

money multiplier where $1 reserves could conceptually support 

even a tenfold increase in the money supply and potentially trigger 

an explosion in inflation. 

This unwelcome prospect explains why economists and some 

members of the FOC are and have been concerned about the need 

to wind down its portfolio and decrease the amount of excess reserves and return interest rates to normal. 

In this context, the Fed ability to pay interest on reserves is critical to keeping interest rates, the money supply, and inflation 

under control, consistent with the Fed’s dual mandate. 

However, there is an additional issue when we recognize, as 

shown in Figure 1 attached to my written testimony, but a substantial portion of the excess reserves in the financial system are 

7 

actually in the U.S. subsidiaries and affiliates of foreign banks, 

which now account for 40 percent of the excess reserves, but only 

about 10 percent of U.S. domestic deposits. 

Because of this imbalance, they also receive a disproportionate 

share of the interest payments on reserves relative to domestic institutions. 

There are really two explanations for this imbalance. First, the 

Dobbs Bank Act changed how deposit insurance assessments were 

charged. Large banks, mainly those over $500 billion, now pay 15 

basis points or more on total assets. 

This means that while they currently earn 50 basis points on 

their reserves, their net return is 35 basis points. It was 10 basis 

points prior to the rate change in December of 2015. 

In contrast, foreign banks aren’t subject to the 15 basis point assessment. They are able to earn the full 50 basis points on their 

excess reserves. But for foreign institutions headquartered in Europe or Japan, for example, where policy rates are now negative, 

the spread is even wider. 

In the case of European Bank it is now 90 basis points, and reserves at the Fed are clearly an attractive asset in earning asset. 

Chairman HUIZENGA. Dr. Eisenbeis, I have to interrupt. Time 

has expired at this point, and we will have to return back to you 

during questions. 

Mr. EISENBEIS. Fine. 

Chairman HUIZENGA. All right, I appreciate that. 

Mr. EISENBEIS. Thank you. 

[The prepared statement of Dr. Eisenbeis can be found on page 

47 of the appendix.] 

Chairman HUIZENGA. Dr. Keister, you are recognized for a generous 5 minutes as well, so, and we thank you for that. 

STATEMENT OF TODD KEISTER, PROFESSOR OF ECONOMICS, 

RUTGERS UNIVERSITY 

Mr. KEISTER. Thank you, Mr. Chairman, Ranking Member 

Moore, and members of the subcommittee. The ability to pay interest on reserves is an important policy tool, and Congress’ authorization of these payments in 2006 was a welcome development. In 

the aftermath of the financial crisis, the Fed has come to rely more 

heavily on this tool than was previously anticipated. 

Because paying interest on reserves is still relatively new in the 

United States, there is naturally some uncertainty in the minds of 

both the public and policymakers about the implications of this 

tool. 

In my comments today, I will argue that continuing to pay interest on both required and excess reserves is not only essential for 

the implementation of monetary policy, but also sound economic 

policy. 

I will focus on four key points. First, paying interest on excess 

reserves has no cost to the taxpayer. To understand why, it is helpful to walk through the mechanics of how bank reserves are created using a simple example. 

Imagine we start with a situation in which I personally owned 

a U.S. Treasury Bond. And the U.S. Government regularly pays inVerDate Nov 24 2008 19:27 Aug 16, 2017 Jkt 024067 PO 00000 Frm 00013 Fmt 6633 Sfmt 6633 K:\DOCS\24067.TXT TERI
8 

terest on that bond to me. Now suppose I decide to sell this bond 

and that the Fed purchases my bond. 

When this transaction takes place, the Fed credits my bank with 

reserves equal to the value of the bond, and my bank credits my 

account in the same amount. In this new situation, the Treasury 

pays interest on the bond to the Fed. 

The Fed pays interest on the reserves to my bank. And my bank 

pays interest on my deposit to me. In other words, the Fed paying 

interest on reserves is a link in a chain of payments that replaces 

payments the Treasury would otherwise be making directly to 

bondholders. 

Seen this way, the operation clearly creates no cost for the taxpayer. In fact, as we have already heard, since the interest rate on 

excess reserves is generally lower than the interest rate on longterm Treasury bonds, the operation creates a net gain for the taxpayer. 

My second point is that paying interest on excess reserves is not 

a subsidy to banks. Suppose I keep the money I receive from the 

sale of the bond in my savings account. Then my bank would be 

earning 50 basis points on the newly created reserves, but it would 

be paying me approximately 30 basis points on my new deposit. 

My deposit also increases the bank’s cost indirectly by raising the 

deposit insurance fees it must pay to the FDIC and by increasing 

its leverage. Overall, the bank may make a small profit on this 

transaction, but to a first approximation it will roughly break even. 

So taking into account the cost as well as the benefits of my deposit to the bank shows that earning interest on excess reserves 

does not represent a subsidy. 

My third point is that policy should be designed to encourage 

banks to hold excess reserves. Bank reserves are the life blood of 

our Nation’s payment system. Every business day, more than $3 

trillion of payments are made over the Fed’s network. Banks are 

making these payments on behalf of their customers using the reserves they hold on deposit at the Fed. 

Prior to 2008 when no interest was paid on reserves, the Fed 

needed to create a scarcity of reserves to keep market interest 

rates positive. In fact, reserves were so scarce that our payment 

system could not adequately function using those reserves alone. 

Instead the Fed permitted banks to run overdrafts in their reserve 

accounts for a few hours each day solely for the purpose of allowing 

the payment system to function. 

These overdrafts were large at times, with an average daily peak 

value of more than $180 billion in 2007. One byproduct of the large 

expansion of bank reserves that has occurred over the last few 

years is that these intraday overdrafts have fallen by more than 90 

percent, decreasing the risk to the Fed and ultimately to the taxpayer. 

In addition, payments are on average being sent earlier in the 

day, eliminating bottlenecks, reducing delays, and enhancing the 

resilience of our payment system. 

This brings me to my final point. The Fed’s balance sheet should 

remain larger than its pre-crisis level even in the long run. While 

the Fed’s balance sheet should and will shrink substantially from 

its current level, it would be a mistake to return to the precrisis 

9 

approach of creating a scarcity of bank reserves to control interest 

rates. 

There have been substantial changes in the financial system 

since 2008, including a greater awareness of liquidity risks, and 

new regulations that are increasing banks’ demand for safe liquid 

assets, such as reserves. 

Going back to the old approach of controlling interest rates by 

creating a scarcity of reserves not only runs counter to the goals 

of these new regulations, but also would likely be less effective in 

achieving the desired level of market interest rates than in the 

past. 

In contrast, the Fed holding a moderately larger balance sheet 

and relying primarily on the interest rate on excess reserves to 

steer market rates would be a more effective way to implement 

monetary policy going forward, while simultaneously promoting 

safety and efficiency in the payment network that underlies our financial system. 

Thank you again for this opportunity to testify before you today. 

I would be happy to answer any questions. 

[The prepared statement of Dr. Keister can be found on page 59 

of the appendix.] 

Chairman HUIZENGA. Thank you, Dr. Keister. 

Dr. Selgin, you are recognized for 5 minutes. 

STATEMENT OF GEORGE SELGIN, DIRECTOR, CENTER FOR 

MONETARY AND FINANCIAL ALTERNATIVES, CATO INSTITUTE 

Mr. SELGIN. Mr. Chairman, Ranking Member Moore, and distinguished subcommittee members, the original intent of the 2006 legislation granting the Fed permission to pay interest on reserves 

was to resolve what in retrospect was a rather minor inefficiency 

in the payment system related to the opportunity costs of holding 

non-interest earning reserves. 

The accelerated deployment of that authority in 2008 was undertaken as a contractionary monetary measure. This was its avowed 

purpose. At the time, the Federal Reserve believed that its emergency lending would create excessive credit in the system and prevent it from reaching its monetary policy targets. 

We know in retrospect that this decision was tragically mistaken. 

Because at the very time that the Fed began to encourage banks 

to hoard reserves rather than lend them, the economy’s total 

spending was collapsing and it continued to collapse afterwards 

from what had been a growth rate of about 3 percent at the beginning of 2007, to a rate of minus 3 percent at the end of 2008, beginning of 2009. 

The combination of interest on reserves, which is designed to prevent banks from lending either to each other or to the market in 

general, and massive reserve creation by the Federal Reserve resulted in a massive accumulation not just of reserves, but of excess 

reserves, that is reserves held without any corresponding increase 

in required reserves that would occur if deposits had also expanded. In fact, bank deposits did not increase despite a tremendous increase in total reserves in the system as they normally 

would. 

10 

Banks before 2008 seldom held more than $1.8 billion in excess 

reserves. At some point after this policy was implemented, after 

the Federal Reserve also had engaged in its third round of quantitative easing, they held $2.7 trillion of excess reserves, and they 

still hold about $2.3 trillion. 

Normally banks shed their excess reserves by trading them for 

higher yielding assets or lending them to other banks. Even if they 

don’t want to incur risk, they can trade their excess reserves for 

higher yielding safe Treasury securities. 

Interest on reserves eliminated the incentive for them to do that 

and to therefore contribute to a more general expansion of deposits 

and credit by making reserves earn more than Treasuries, as they 

have done for the most part ever since the policy was implemented. 

The result, to use some economics jargon, is that the normal 

money multiplier, which gives you the relationship between total 

bank reserves in the system and total money supply including bank 

deposits, collapsed. 

This caused quantitative easing to be much less effective in increasing spending, income, and employment than it would have 

been otherwise. Because almost all the new reserves created by the 

massive quantitative easing programs the Fed undertook simply 

piled up in banks and mainly, as Dr. Eisenbeis just explained, in 

foreign banks. 

The large expansion of the Fed’s balance sheet that has gone 

along with this hoarding of bank reserves, and what I mean is that 

has been made the accumulation of excess reserves possible, has 

also involved, because banks have not increased credit proportionately, a tremendous increase in the Federal Reserve’s share of financial intermediation from about 10 percent of total allocation of 

credit in the economy, of money-based credit, to just about 30 percent. 

Ladies and gentlemen, central banks have never been intended 

to be efficient allocators of the Nation’s scarce savings. And the Fed 

is no exception. It was an inefficient investor of savings before the 

crisis. 

Naturally, it was never intended to be looking for productive 

lending opportunities. The changes in its balance sheet since have 

made it a far more inefficient employer of savings. The inefficiency 

that results from the Feds having nationalized so many savings far 

exceeds those that the original Act allowing payment of interest on 

reserves was supposed to correct. 

Ladies and gentlemen, I have very little time, but I will simply 

say that contrary to what some of the other speakers have said, we 

desperately need to return to the old-fashioned way of conducting 

monetary policy by having the Fed unwind its balance sheet, get 

rid of the assets it has accumulated, allow banks to earn interest 

only on required reserves, and encourage them not to hold excess 

reserves but instead to engage in productive lending. 

I am going to yield the rest of my time to Professor Taylor, who 

is a lot smarter than I am. Thank you. 

[The prepared statement of Dr. Selgin can be found on page 67 

of the appendix.] 

Chairman HUIZENGA. With that, your time has expired, Dr. 

Selgin, but we are very pleased to— 

11 

Mr. SELGIN. Oh, thank you, sorry. 

Chairman HUIZENGA. —welcome Dr. John Taylor back to the 

subcommittee, and we look forward to your testimony. With that, 

you are recognized for 5 minutes. 

STATEMENT OF JOHN B. TAYLOR, MARY AND ROBERT RAYMOND PROFESSOR OF ECONOMICS AT STANFORD UNIVERSITY 

Mr. TAYLOR. Thank you, Mr. Chairman, Ranking Member Moore, 

and other members of the subcommittee, for inviting me to talk 

about this important but complicated subject, interest on reserves 

and the Fed’s balance sheet. Since reserves are such a large part 

of the Fed’s balance sheet, I thought maybe we should look at the 

balance sheet to begin. So I put a picture on the front page of my 

written testimony. I have simplified it a bit, but basically it is the 

main issues. 

If you look at that, you can see that the size has increased. Measuring by assets it has gone from $842 billion to $4,478 billion. Part 

of that is because currency has increased. Currency has gone from 

$758 billion to $1,407 billion. That is not unusual; that is the 

growth of the currency. 

What is unusual is this gigantic increase in securities, purchase 

of Treasury securities and mortgage bank securities by the Fed, 

which have gone from $760 billion to $4,234 billion. All those figures are in the table. 

Finally, what this has led to is a literal explosion of reserves. Reserve balances is what the Fed calls it. From $14 billion to $2,401 

billion. I have a chart on page 2 of my testimony which shows that 

this occurs quite dramatically. This occurred of course to finance 

the purchases of these securities. 

In the correspondence with QE1, QE2 and QE3, each successively jumping the amount of reserves, is what shows you that 

close correlation between the need to finance QEs and the financing through reserve creation. 

When you increase the supply of reserves so much, basic economics tells you that is going to drive the market interest rate down 

close to zero. And in fact it did in the fall of 2008, very rapidly, 

even faster than the Fed was able to adjust its target. There is another chart showing that in my testimony. 

But the fact that such a gigantic increase in supply of reserves 

will drive the interest rate down brings us to the topic of this hearing. Because to prevent that, the Fed has instituted interest on reserves and taken the legal, the law to do that. 

I think this disconnect between the interest rate set by the Fed 

through interest on reserves which you could see had happened in 

December, they want to raise the interest rate by 25 basis points 

so they raised interest on reserves by 25 basis points. No necessary 

change in the amount of reserves to do that. 

So there is a disconnect between the interest rate the Fed is setting and the amount of reserves, the amount of money in the economy. I think that disconnect is necessary now because of this gigantic amount of reserves. There is no choice. Otherwise, the rate 

will fall to zero. 

12 

But as a long-term proposition, I do not think it is a good idea 

to make that disconnect. It does give the Fed another tool. But 

quite frankly it enables the Fed to what I would call a multipurpose discretionary institution instead of a rather limited purpose 

rules-based institution, that extra tool gives it the ability to do 

that. 

In this instance, I think it is promising that the Fed in their policy normalization principles and plans said that in the longer run 

they will hold no more securities than necessary to implement 

monetary policy efficiently and effectively, and that we will hold 

primarily Treasury securities. 

I would like the Fed to describe to us what effectively, primarily, 

and efficiently means, because it is not clear. I think it would be 

very useful if the Fed said they were going to bring that balance 

sheet down to a level where the supply and demand reserves determined the interest rate as in any other market, a market that determined the interest rate. 

To do that, to clarify that they are not going to have to pay interest on excess reserves in that mode, and remember that gigantic 

increase in reserves will come down substantially. We don’t know 

how much it will come down, but come down to the point where 

the interest rate is determined by the supply and demand for reserves or money as it has in the past. 

And again, it is true that this gives you an additional tool. But 

I think that additional tool is one of the problems we have. It 

would be important for the Fed to say we are going to set monetary 

policy. 

Not with this extra instrument, which enables it to do so many 

other things including credit allocation, things that are properly 

fiscal policy. It is not the job of the Fed to do fiscal policy and credit allocation, but this extra tool enables them to do that. 

I say, go back to the basic way it worked before. The world is 

different, it is not exactly the same. I think we will have a better 

Fed, a better monetary policy in that situation. 

Thank you, Mr. Chairman. 

[The prepared statement of Dr. Taylor can be found on page 83 

of the appendix.] 

Chairman HUIZENGA. Thank you, Dr. Taylor. 

I can see we have a lot of issues to dive into in a very short period of time. And with that, I am going to recognize myself for 5 

minutes for questions. 

I will point out to my colleagues that we had a similar panel of 

Ph.D. economists, concerning the stimulus, and I asked the question, who here on the panel believes it should have been about half 

the size? A few hands went up. I asked who, here believes it ought 

to have doubled? One hand went up. 

And the simple fact is that economists are split as to whether we 

had spent half as much or twice as much, we would probably end 

up about right where we are. The question is, do you want more 

debt or less debt as we are moving forward. 

Dr. Eisenbeis, I know you got cut off a little bit, but the Treasury 

is making the payments as a profit was a point made. I am curious 

if you would like to still continue to unpack that. 

13 

I know Dr. Keister had an opposite view of that. And I am going 

to quickly try to move along to Dr. Taylor. And then the main question that I have is how in the world are we going to unwind all 

this, and Dr. Taylor was starting to get at that. So, Dr. Eisenbeis? 

Mr. EISENBEIS. I think that the proper way to view the interest 

payments, and what Dr. Keister was essentially addressing was 

from the perspective of the financial institution, how it deployed 

those funds once received and how it affected the customers. 

I was talking more about how one should view the transfer of 

funds from the Treasury to the Federal Reserve, and essentially my 

main point was that it is the Treasury who is paying the interest 

on reserves. 

When it comes to unwinding the balance sheet, the Fed faces a 

really difficult problem. Because if you just let the Treasury securities run off, it would take until about, through the normal maturing process, until about 2029 before you would return the balance 

sheet to something close to what I would call equilibrium, where 

essentially mainly you have, as Professor Taylor was talking about, 

sufficient excess reserves to conduct monetary policy, and then 

backing of the currency, which would imply a currency level somewhere around $1.3 trillion or thereabouts. 

Chairman HUIZENGA. Thank you. Sorry, I have to quickly move 

along. I would like to use a Bloomberg chart that used Dr. Taylor’s 

information, but I would be remiss if I didn’t take an opportunity 

while having Dr. Taylor here to talk about a rule-based Fed policy 

and sort of where the Federal funds rate was and where that dotted line is. 

What the ideal rate is calculated by the Taylor Rule. It pretty 

much shows, it looks like the Fed was somewhere, two to maybe 

three or four quarters behind you, Dr. Taylor, on where they 

should have gone. Do you care to address this and take a stab at 

where we are at? 

Mr. TAYLOR. Yes, thank you, Mr. Chairman. I think what this 

shows is in the period before the crisis, the interest rate set by the 

Fed was much lower than it would have set had it been operating 

policy as in the 1980s and 1990s. It then caused search for yields, 

excesses in the housing market, and eventually the bust. So, it is 

a real concern. 

If it was closer to the rule, whatever rule, it would have been 

better. During the panic period, they came and brought interest 

rates down very rapidly. It seemed appropriate. But since then the 

rate has been not what I would say rule-based as in the past, hanging at around zero, and I think that has been a problem. 

Chairman HUIZENGA. And I know that I had suggested that the 

Chair could create the Yellen rule at some point or another, that 

if there was any kind of rule that needed to be had, and that is 

part of our FORM Act, the Federal Oversight Reform and Modernization Act, that has passed the House. 

I would like you to quickly, Dr. Taylor, I know you were starting 

to talk about that on page four and five of your written testimony, 

what happens when the IOER, the excessive reserves, interest on 

excessive, not the required but the excessive reserves declines, who 

benefits from that? You were starting to talk about that and Dr. 

Eisenbeis was a little bit, but do you care to address that please? 

14 

Mr. TAYLOR. At this point, I think the testimony by Mr. 

Eisenbeis makes this clear. It is necessary to do this because reserves are so high. So, if they want to raise the rates they have 

to. But it’s as if the Fed has been borrowing instead of the Treasury, so in that sense it is a wash. 

My concern is that this extra instrument really creates many 

other ways for the Fed to intervene in the economy, and I think 

people don’t benefit from that. Maybe one sector will benefit, but 

that is not the job. The Fed is not supposed to help certain sectors. 

It is supposed to help the whole economy. That is why it has been 

successful when it has done that. 

Chairman HUIZENGA. Just so we are clear, Dr. Selgin, we have 

5 seconds. 

Mr. SELGIN. I actually had another point. 

Chairman HUIZENGA. Okay, but my time has expired. So with 

that, the Chair recognizes the ranking member of the subcommittee, Ms. Moore, for 5 minutes. 

Ms. MOORE. Thank you so much, gentlemen, again, for appearing. I have to say that the chart you just put up, Mr. Chairman, 

was very confusing to the extent that it was more theoretical than 

anything. 

I guess I am confused, and I guess I will let Dr. Taylor and Dr. 

Keister sort of explain this to us further. I think that the Fed has 

been operating under their mandate. 

The Taylor Rule has been an intellectual discussion, and it is not 

something that the Fed has relied on. And right now, the current 

Fed is operating under that same mandate. And they were operating under that mandate in the period that you used to calculate 

your Taylor Rule. So let me start with Dr. Keister. Can you respond to the chart we saw? 

Mr. KEISTER. Sure. I think it is important to remember as we 

focus, for example, on that period in the early 2000s when the 

Fed’s interest rate was lower than the Taylor Rule would have suggested, that there were very real risks at that time. 

After the crash of the stock market and the collapse of the 

dot.com stocks, there was a very real risk of falling into a deeper 

recession and we were worried about deflation. The fact that those 

risks did not materialize doesn’t mean the Fed got it wrong; it 

could be interpreted as meaning the Fed got it exactly right. 

It is by easing policy more than would have been suggested by 

a rule that was based on an earlier time period, the Fed mitigated 

those risks and helped the economy recover. 

Ms. MOORE. Okay. Dr. Taylor, Dr. Keister essentially said that 

the Taylor Rule really didn’t take into account the recession, didn’t 

really take into account other risks to the system, and I guess I 

would give you an opportunity for a few seconds to respond to that. 

Mr. TAYLOR. There are many reasons the Fed and people who 

worked at the Fed give to explain why the interest rate was so low 

at that point in time. You just heard one of them. There are others: 

that there were international effects; that we couldn’t do much 

about interest rates. 

I think the bottom line is, it is not theoretical. It is based on 

what worked in the 1980s and 1990s until this time. We had basiVerDate Nov 24 2008 19:27 Aug 16, 2017 Jkt 024067 PO 00000 Frm 00020 Fmt 6633 Sfmt 6633 K:\DOCS\24067.TXT TERI
15 

cally a good, stable economy. We had a few recessions, but the ones 

that occurred were mild. 

Unemployment was much better than what happened in this 

Great Recession. So, that experience has led people, economists to 

think that kind of a policy is not rocket science; it is better than 

one that just ignores it. And when the Fed ignores it, it causes 

problems and that chart shows it big time. 

Ms. MOORE. Dr. Keister? 

Mr. KEISTER. Sure. My main concern about the format is that 

any rule that performed well in a certain time period may not perform as well in the future. I think we want the Fed to be forwardlooking, not backward-looking in its policies, and we want the Fed 

to react as there are changes in the environment. 

Recovering from the financial crisis as the Fed’s balance sheets 

continue to normalize, I think we should expect the environment 

to be different than it was, particularly in the 1980s and the 1990s. 

And we would like the Fed to have to maintain the flexibility to 

react in the most appropriate way as the environment continues to 

evolve. 

Ms. MOORE. I want to change the subject just a little bit with my 

remaining time. 

To you, Dr. Keister, if the Fed’s goal ultimately is to help our 

economy grow, we are suffering from low growth. The presence of 

these reserves theoretically, even if there is a disincentive to lend 

it from bank to bank, there still is an incentive to provide these resources to economic development and to businesses with what the 

Fed is doing. Am I correct in that? 

Mr. KEISTER. Yes. That is exactly. And that is a point that I hope 

that my little simple example helps clarify. So, when the Fed purchases the bond from me, it is holding reserves, but it also has a 

new deposit from me. That doesn’t in any way prevent my bank 

from being able to make loans and create credit for businesses and 

consumers. 

By holding more reserves, the bank is safer, and it is sounder, 

but it still has every bit as much incentive to lend out to customers. 

Ms. MOORE. Okay. Thank you. I yield back— 

Chairman HUIZENGA. The gentlelady’s time has expired. With— 

Ms. MOORE. —4 seconds left. 

Chairman HUIZENGA. Yes, I can grant you the 4 seconds back if 

you would like. 

Ms. MOORE. No, no. I am just saying that I yielded back. 

Chairman HUIZENGA. Okay. Point taken. So with that, the Chair 

recognizes the vice chairman of the subcommittee, Mr. Mulvaney of 

South Carolina, for 5 minutes. 

Mr. MULVANEY. Thanks very much, Mr. Chairman. 

I don’t know where to begin. A couple of different topics. Dr. Taylor, you said something towards the tail end of your testimony that 

the tool, the interest rate on reserves, allowed the Fed in effect to 

set fiscal policy. Did I hear you correctly, sir? Could you expand on 

that a little bit if that— 

Mr. TAYLOR. Yes. That is what I said. So, given that the interest 

rate can be determined by this interest on reserves, means the balVerDate Nov 24 2008 19:27 Aug 16, 2017 Jkt 024067 PO 00000 Frm 00021 Fmt 6633 Sfmt 6633 K:\DOCS\24067.TXT TERI
16 

ance sheet can go wherever it wants to go. Just as that is the disconnect that I mentioned. 

So, in that circumstance, the Fed could buy mortgages. It could 

even buy student loans. It could buy automobile loans. In fact, of 

course, it did buy mortgage-backed securities early on. 

Mr. MULVANEY. But they can do that— 

Mr. TAYLOR. But that is a credit allocation issue. It seems to me 

that is the kind of thing that Congress should be deciding, which 

agency should be doing that. 

Mr. MULVANEY. I don’t think I am disagreeing with you, but they 

have that ability. I asked Chair Yellen about that, and her predecessor as well. They have that ability anyway, don’t they? They 

could buy municipal debt if they want to. 

That is one of the authorities they have. 

Mr. TAYLOR. I think the difference is if the balance sheet and the 

supply of reserves has to be at a level—the supply is at a level 

where it is equilibrating the interest rate. It doesn’t have the ability to move it anywhere it wants. 

The connection between interest and money is a classic one. 

Mr. MULVANEY. Yes. 

Mr. TAYLOR. They have severed that. And so, that means there 

is much more ability to expand the balance sheet. They could not 

have expanded the balance sheet to where it is now in my picture 

and still be able to have a positive interest rate without this tool. 

Mr. MULVANEY. Dr. Selgin, do you have any thoughts on that? 

Mr. SELGIN. Yes, sir. The difference that interest on reserve 

makes is that by encouraging banks to hold large quantities of excess reserves it effectively gives the Federal Reserve a larger share 

of savings to play with, and to intermediate. 

And that, in turn, means that whatever assets the Fed chooses 

to buy and hold, that its influence on the overall allocation of credit 

is much greater under an interest on reserve regime that it would 

normally be. 

Mr. MULVANEY. Have you gentlemen given any thought to why 

this—my understanding is that when this tool was used in December of 2015, it was the first time it had been done. Chair Yellen 

was here before that, and the Fed had anticipated that, hinted that 

they were going to use this tool. 

I remember asking her at a hearing why she expected to use that 

tool as opposed to moving the Fed funds, right? Or some other traditional tool, shrinking the balance sheet, for example. And she 

said, well, you know, the answer is what we always get. Which is 

we have many tools available to us. We just happened to pick this 

one this time. 

Do you gentlemen have any thoughts as to why you think this 

tool was used in December of 2015 and not one of the more traditional tools? Dr. Selgin? 

Mr. SELGIN. The fact is that the Federal Reserve was unable to 

use its traditional tools. Let me go back to when they first implemented interest on reserves, just for a moment. 

The original idea was that interest on reserves would put a floor 

on the actual effective Federal funds rate, and that would help the 

Fed to keep its target, which was still above zero at that time. It 

didn’t work out that way. The effective rate at which actual 

17 

tradings were occurring continued to be below and to fall further 

below the Fed’s target. 

Subsequently, they changed how they described their target by 

saying, the target is now a bend, where the interest on reserves is 

the upper part of the bend, and the lower part is either zero or subsequently the overnight repo rate. 

Frankly, it is like an archer who misses a target then moves the 

target, and then says, see, now we are meeting the target again. 

Mr. MULVANEY. I follow that. But, again, why? Why would they 

use that tool and not another one? Why were the other tools ineffective? 

Mr. SELGIN. The alternative would have been to raise interest 

rates by selling assets. And because the Fed had acquired such a 

large proportion of mortgage-backed securities, which it did not 

dare sell, and could not sell for much, and because of long-term 

Treasuries it held, it feared the balance sheet repercussions to 

itself, the capital losses, and also the consequences for the values 

of these securities in the market. 

Mr. MULVANEY. Does the Fed have to mark the assets on its balance sheet to market occasionally or not? 

Mr. SELGIN. No, it does not. And it is an interesting question because the Fed, unlike normal banks, can actually become insolvent 

and have negative capital without closing shop. The problem is in 

the income statement where, of course, it would have to go hat-inhand to Congress if it were not able to earn enough income to cover 

its operating expenses. 

Mr. MULVANEY. I hope we get a second round. I thank the chairman. Thank you, gentlemen. 

Chairman HUIZENGA. Thank you. The gentleman’s time has expired. With that, the Chair recognizes Mr. Foster of Illinois for 5 

minutes. 

Mr. FOSTER. Thank you. Let us say, Dr. Eisenbeis, if the Fed just 

let all of the assets run down, that it would be around 2029, I think 

you said that. And is that sort of similar what is happening over 

the last couple of years where, I believe, they are trending down? 

Mr. EISENBEIS. No, they haven’t been trying to reduce the balance sheet at all. They have been reinvesting and maturing the 

portfolio— 

Mr. FOSTER. Then we— 

Mr. EISENBEIS. So, they have not yet made the decision to stop 

reinvesting and let the balance sheet run off. So, my— 

Mr. FOSTER. Okay. 

Mr. EISENBEIS. —number assumed that they would do that now. 

The longer they postpone then that 2029 figure gets pushed out 

further. 

Mr. FOSTER. Okay. And is there an understanding, an agreement 

on what would happen if they let it run down on the trajectory you 

talked about, unload things faster or slower? What effects that 

would have on short-term, that effect, by itself, on short-term and 

long-term interest rate? 

Mr. EISENBEIS. In the short run, what it would do is if the Treasury in particular maintained the volume of outstanding securities, 

this would put more collateral into the marketplace, and relieve 

18 

some of the pressure on collateral and have an implication for interest rates. 

So, right now, the argument is that size of the balance sheet because of the interest rate impacts we have been talking about is 

actually a tightening. This would actually free up and be a little 

bit more of a moderating force on interest rates as a whole. 

Mr. FOSTER. Is there a limit on how rapidly you think they 

should unwind the balance sheet? 

Mr. EISENBEIS. The problem is that they risk if they have to unwind it faster and if that is necessitated because of restrictions on 

interest payment on reserves or inability to sort of sterilize the excess reserves, if the money supply started to grow too rapidly, then 

they would have to sell assets. 

And if interest rates are rising during this environment, which 

presumably would be the case, they would have to sell those assets 

at a capital loss. And rather than recognizing the capital loss on 

their balance sheet, they would be able to create what is called a 

deferred asset account or a negative asset account. 

And try to get your head around what a negative asset account 

is. 

Mr. FOSTER. I will. That is the end run guys. 

Mr. EISENBEIS. But if you match that negative asset account 

against their capital account they could quickly go insolvent as Dr. 

Selgin has indicated. And how would the world respond to seeing 

a negative— 

Mr. FOSTER. Okay. So it sounds like the default scenario here 

would be just to let everything run down by about 2029, and then 

use other tools to regulate interest rates as it, sort of, gradually. 

Is there anyone who believe that scenario would not work and 

could not be made to work? 

Mr. EISENBEIS. My problem with that is 2029 is a ways away, 

and that the whole period is it almost becomes permanent, that 

particular method of controlling the interest rate. I think that it 

would be far better to bring the balance sheet down, bring reserves 

down more rapidly if it is done strategically, clearly, I don’t think 

it should be a problem. 

There is huge controversy about how much Q.E. actually did anything to interest rates. I think it sometimes surprised the market 

and moved rates, but if it was clear I think they could reduce that 

balance sheet much more rapidly than 2029. 

Mr. FOSTER. Okay. Dr. Selgin, you indicated at one point that the 

Federal Reserve couldn’t sell the MBS’s that it owned. Weren’t 

these government-backed MBS’s? Was there ever a point when 

they could not sell them? 

Mr. SELGIN. The problem isn’t that they can’t sell them; the 

problem is they can’t sell them for anything like what they are valued at on their books. So it is the problem that we have been talking about, about the Fed bearing losses on those securities by selling them. 

Mr. FOSTER. Did this have anything to do with the fact that they 

were mortgage-backed securities, or just the fact that— 

Mr. SELGIN. They were mortgage-backed securities purchased— 

Mr. FOSTER. But it had nothing to do with the mortgage market 

directly— 

19 

Mr. SELGIN. No, they were mortgage-backed securities purchased 

during the crises precisely because their values at the time were 

doubtful and they were purchased as part of an emergency effort 

to help the financial institutions that had been holding those assets. 

Mr. FOSTER. Okay. Yes. I may have some follow-up questions. I 

don’t completely understand that risk because I thought at the 

time that these were government-backed MBS’s, and, in fact, it was 

not noticeably different than buying other government-backed assets. 

Anyway, okay. Let us see. Just a final observation on the very 

first plot that showed the deviation from the Taylor Rule. I think 

if you look at point of maximum deviation, and then think about 

when elections were being held, I think you come up with an interesting argument for an independent Federal Reserve. And with 

that, I will yield back. 

Chairman HUIZENGA. The gentleman yields back. Point well 

taken. With that, we will be going to Mr. Pittenger of North Carolina for 5 minutes. 

Mr. PITTENGER. Thank you, Mr. Chairman. And I thank each of 

you for being with us today. Mr. Eisenbeis, if the Fed’s balance 

sheet strategy was working, then why haven’t normal market conditions returned even after 8 years of financial panic? 

Mr. EISENBEIS. Could you repeat the question, sir? 

Mr. PITTENGER. If the Fed’s balance sheet strategy was working, 

then why haven’t normal market conditions returned, even after 8 

years? 

Mr. EISENBEIS. That really depends upon how they employ the 

tools that they use and what the growth rate in the economy is, 

and how sick of it, if we are on the present path there is a chance 

that they could get into a normalization situation, but I think the 

risk is that if the economy starts to pick up growth because it is 

one thing if they are growing at 2 percent. 

But if the economy starts to grow, that means that inflation is 

going to potentially start to pick up. And then, they are in a bind 

as to what to do. 

Mr. PITTENGER. As such, what is stopping the Fed at this point 

from naturally winding down the balance sheet? 

Mr. EISENBEIS. I think they are really in a risk adverse situation 

and risk management at this point in time. They are just really 

cautious about the fact that they have not been achieving their inflation objective. 

The labor market clearly is improving and doing quite well by 

comparison, but they are essentially wanting to keep their foot on 

the throttle from their perspective to get inflation up to their 2 percent target. 

Mr. PITTENGER. Thank you. Dr. Selgin, in terms of economic opportunity how much damage is being done from leaving the balance 

sheet too big for too long? 

Mr. SELGIN. I wish I could give you an answer to that question. 

What we can say is that the holding of, or the allocation of so much 

savings to the sectors that the Fed’s balance sheet is supporting 

certainly does not contribute to productive investment as it might 

20 

if the same savings were allocated by the commercial banks and 

other private lenders. 

We know that none of it is supporting lending, commercial lending of any kind. It is certainly not supporting lending to small businesses that is regarded as very important to a recovery. I believe 

it is an important factor, by no means the only important factor in 

the sluggish economy. 

And I believe it is one of the reasons why we have, despite the 

Fed’s seemingly aggressive monetary expansion, we haven’t really 

seen a very robust recovery coming out of that. The best that people can say is that it is not as bad as Europe. This doesn’t seem 

to me to be a very clear endorsement of what the Fed has been up 

to. 

Mr. PITTENGER. Thank you. And in terms of monetary policy 

independence, what damage is leaving the balance sheet too big for 

too long? 

Mr. SELGIN. Sorry, could you repeat that? 

Mr. PITTENGER. In terms of monetary policy independence, what 

damage is it to leave the balance sheet too big for too long? 

Mr. SELGIN. That depends on how Congress responds to having 

such a big balance sheet and having the Fed maintain it, of course. 

I think that there is no reason why the Fed can’t continue to be 

independent. But I think that Congress should limit its dependence 

to the extent of trying to tell it that it should not stay in this situation forever. 

If it is undermining Fed independence to merely tell them to go 

back to business as usual and to do it as quickly as possible, well, 

then I say the Fed has rather too much independence to begin 

with. 

Mr. PITTENGER. Thank you. Dr. Taylor, to what extent does the 

remarkable expansion of the Fed’s balance sheet mitigate the financial crises? 

Mr. TAYLOR. I think in the fall of 2008 when they provided lender-of-last-resort loans in the panic, in this panic period, it seems 

that was overall good monetary policy. And that is when the balance sheet first began to expand. 

However, those liquidity facilities drew up very quickly. I think 

after that, certainly after early 2009 I raised big questions as to 

whether that did any good at all. There are lots of studies. I did 

an early study back in 2009 which said it was not effective. Some 

argue it is actually counterproductive. 

Mr. PITTENGER. To what extent then did it exacerbate the problem? 

Mr. TAYLOR. I think it is exacerbated the problem because it 

really delayed the time where the Fed could get back to the kind 

of policy that worked so well in the past. It has been a reason for 

them not to go back. And just this very discussion is they find it 

so difficult to reduce the balance sheet. 

It shows you one of the concerns many of us had about the increase in the balance sheet in the first place. It is almost like a wetold-you-so type of thing. Although, I am not doing that right here. 

Mr. PITTENGER. Thank you. My time has expired. Unless the 

chairman wants you to comment? 

21 

Chairman HUIZENGA. The gentleman’s time has expired. With 

that, the Chair recognizes Mr. Himes of Connecticut for 5 minutes. 

Mr. HIMES. Thank you, Mr. Chairman. And I am not sure I have 

a lot in the way of questions. But I am here and I am concerned 

about this because big picture, what we are talking about is something that maybe some of my colleagues don’t appreciate, which is 

the profound importance of the independence of monetary policy, 

and of a flexible central bank. 

Most Americans can understand why a strong military is important to national security, and why high taxes can affect economic 

vibrancy. Most of them don’t necessarily get the historical fact that 

an independent and flexible and smart central bank is the very cornerstone of a functioning capitalist economy. 

And I can’t help but feel that this hearing and the ongoing Fed 

bashing by my Republican friends and the scaling back of authorities and the audit the Fed are all part of an effort that if they are 

joined, the legacy of those who join in on that effort will be to erode 

one of the very cornerstones of this country’s vibrant economy, 

which is an independent monetary policy. 

If we had had a Fed-caused disaster, I would understand why we 

would be having this conversation. But the reality is that in the 

last 8 years or so, the Fed was the one adult in the room. And I 

made this point in my opening statement. 

Congress failed in its responsibility to provide enough fiscal stimulus to do what it should have done. In the absence of good fiscal 

policy, and I am going to come back to this because the chairman 

took exception to what I characterized as an economic consensus, 

the Fed was the only game in town. 

And it is a fair thing to question what their authorities are, and 

to provide oversight, I have no doubt. But the reality is that their 

actions had results which show themselves in the fact, Mr. Selgin, 

that our economic recovery in combination with the decline of the 

deficit is the envy not just of Europe, but of every industrialized 

country. 

So we have been—if we had gotten it wrong and we are at the 

bottom in that stack, I get this. But, Mr. Chairman, and I don’t 

mean to pick on the chairman on this, holds up as his counterpoint 

to my contention on the stimulus that a bunch of witnesses, four 

or five, selected, of course, by the chairman himself and the Majority party, raised their hands to say they didn’t like the stimulus. 

Reality matters. I counter to the chairman the initiative of global 

markets, which is a survey conducted by the University of Chicago, 

hardly a hotbed of liberal thought, has surveyed economists across 

the political spectrum on the stimulus for a long time. 

Its most recent survey had 36 out of 37 economists saying that 

the stimulus actually improved the economy and reduced unemployment. Reality matters. 

And the reality is that we are criticizing the very people and 

eroding the monetary independence of the very people who were 

the one adult in the room with scare tactics. Ooh, some of this 

money is going to foreign banks. 

Well, guess what? Toronto Dominion, T.D., they extend mortgages in my district in southwest Connecticut. I know it is scary 

to say that we are sending money to foreign banks, but it is actuVerDate Nov 24 2008 19:27 Aug 16, 2017 Jkt 024067 PO 00000 Frm 00027 Fmt 6633 Sfmt 6633 K:\DOCS\24067.TXT TERI
22 

ally, as a politician, a little bit, for an economist, a little bit of a 

cheap political trick. 

The reality is that this policy has worked. Now, again, most of 

my constituents and most people here don’t really understand what 

we are talking about. It is hard, this stuff. So, let me offer an analogy. 

We had a major car crash. We talk about the crash a lot. Let us 

envision this as a car crash. What happened in 2008 was a car 

crash where four people are bleeding in the street. And Congress 

said, instead of four ambulances we are sending you two. 

So, two people get taken off. This is the stimulus. And there are 

two people bleeding in the street. And the Federal Reserve says, 

geez, there are people bleeding in the street. We are going to send 

some helicopters, as they do from time to time. And, yes, that is 

extraordinary. We probably shouldn’t do it for every car crash. But 

we didn’t do what we needed to do. 

And so, now you have helicopters carrying people to the hospital. 

Nobody says that is the right way to do it, but it was the only way 

to do it. And the patients all lived. And now we are saying, my 

God, the helicopters were expensive, and there is glass in the 

street. And it scared the neighbors. We shouldn’t use helicopters. 

Folks, it was the only game in town. Now— 

Chairman HUIZENGA. Will the gentleman yield? 

Mr. HIMES. I will yield when I am finished. 

This was a tool that worked in literally a crash. And so, I appreciate the equanimity that Dr. Taylor is showing in particular. I 

don’t think anybody wants this to be a standard tool, but, please, 

Mr. Chairman, and then I will yield, let us be very, very careful 

about scaling back authorities that had everything while we were 

negligent to do with the recovery, and that we may need, heaven 

forbid, but we may need in the future. 

And, yes, I will yield to the chairman. 

Chairman HUIZENGA. Thank you. I appreciate that. And I am assuming that if one is intellectually honest, one will also acknowledge that the drag on the recovery of the economy has oftentimes 

been linked to the Affordable Care Act (ACA). It has oftentimes 

been linked to the regulatory environment that has been created, 

the tax policy that even our own President has said needs to be reformulated. 

Mr. HIMES. I will reclaim my time, and say, yes, those things 

have been linked to the recovery by my friends in the Republican 

Party. If you actually read, for example, the Federal Reserve, who 

we are talking about, they will tell you that this is a crisis of aggregate demand. 

They won’t mention the Affordable Care Act. They won’t mention 

taxation. They will mention it is an issue of aggregate demand. 

With that, I note that I am out of time. 

Chairman HUIZENGA. The gentleman’s time has expired. With 

that, the Chair recognizes the gentlelady from Utah, Mrs. Love, for 

5 minutes. 

Mrs. LOVE. Thank you, Mr. Chairman. Just a few questions and 

then I will yield back the remainder of my time if I have some 

time. Thank you for being here. 

23 

As I have observed, the Fed has consistently and often badly 

overshot its mark in projecting economic growth, reflecting a misplaced belief that repeated rounds of quantitative easing, a $4.5 

trillion balance sheet, and low record policy rates, could reliably get 

our economy back on track. 

Earlier this year, for instance, Forbes even mentioned that at the 

beginning of every year since 2008, economists have predicted its 

actions would produce a robust expansion. And each year has had 

to sharply downgrade those expectations. 

I guess the first question is, do you agree with that assessment? 

Are you seeing the same thing, Dr. Taylor, when it comes to the 

Fed’s predictions? 

Mr. TAYLOR. Yes. They have over-forecast the growth rate consistently through this period, I think to some extent thinking that 

their policy would be more effective. They will punt for other reasons, but that is a big factor. 

Mrs. LOVE. Okay. So, I guess the question here, the basic question for me is why, despite such sophisticated models, does the Fed 

consistently miss the mark? And why not use those models to fuel 

a robust economy, or a robust recovery, as opposed to putting the 

brakes on economic opportunity? Dr. Selgin? 

Mr. SELGIN. If they had good models, they could do what you say 

the problem is that their models are not very good. And when they 

employ wrong models, they take wrong policy actions, like the December rate hike, which was, at best, counterproductive. 

Mrs. LOVE. So, you are thinking that the models are just— 

Mr. SELGIN. Yes. And— 

Mrs. LOVE. —not very good models. 

Mr. SELGIN. —the fact is that the Fed—the Fed can do damage 

when it employs bad models, and it is experimentation often backfires. 

And this is why in Fed independence, to conduct monetary policy 

in the sense of being free to set the policy rates, which is the normal understanding of independence, to determine general monetary 

conditions, is not the same thing as Fed experimentation with activities and programs that it has never engaged in before. Independence isn’t license. 

Mrs. LOVE. Okay. So, I guess this is my final question because 

I think the important thing in the work that we do here, is to try 

and figure out how this relates to the everyday person. What does 

this mean for the family who is sitting at the kitchen table if we 

continue to have these types of practices, and these models that are 

not working? 

What does that mean for the family? Did you have something 

you wanted to add, sir? 

Mr. EISENBEIS. I would like to respond briefly in the sense that 

you have to understand that the models that were being employed 

did not include experiments and experience like the Great Recession that we had. 

So, the data that are underlying the models, essentially mean 

that the current environment that we were in is out of sample forecasting, and the models didn’t incorporate the kind of behavior and 

responses that the economy was in at this particular point in time. 

24 

Mrs. LOVE. So, you are saying it was behind, we were behind the 

ball? 

Mr. EISENBEIS. There is no way you can generate data that 

would have essentially allowed the Fed on a current basis to revise 

the models in a way to capture the current economic environment. 

So, this is a characteristic of forecasting as a whole. We know 

that based on experiments that I did a long time ago that showed 

that the Fed’s models essentially are as good as anybody else’s, and 

better than most. 

But when you have an environment and an economic environment degenerating out of the normal behavior, you are going to 

have these kinds of errors. And there is really virtually no way to 

fix it. 

Mrs. LOVE. Okay. I have 25 seconds. Dr. Selgin, again, what does 

this mean? If we continue, what does this mean for the family who 

is sitting at home? How does that affect regular hardworking 

Americans? 

Mr. SELGIN. The biggest effect comes through the lack of private 

investment, productive investment, small business investment, as 

a result of the fact that the Fed, through its encouragement of 

banks to hold reserves, and they cannot both hold reserves and 

loan. 

They are either holding one kind of asset on their balance sheet, 

or another, in real terms. This has a drag on the economy. And I 

would like to also add to that, with respect to what Congressman 

Himes said, the Fed did not add an ambulance to the batch when 

it paid interest on reserves. It took one away. 

Interest on reserves in 2008 was a contractionary measure which 

took away from aggregate demand, and its avowed purpose was to 

keep banks from lending the new reserves that were being created 

at the time. 

So, if you want aggregate demand to grow, and I think it desperately needed to grow at that time, if you want to have enough 

ambulances, you don’t want the policy of interest on reserves implemented in the middle of a contraction. 

This is simply getting reality, which does, indeed, matter, wrong. 

Mrs. LOVE. Thank you. My time has expired. 

Chairman HUIZENGA. The gentlelady’s time has expired. 

Mrs. LOVE. Thank you. 

Chairman HUIZENGA. With that, the Chair recognizes the gentleman from Washington, Mr. Heck, for 5 minutes. 

Mr. HECK. Thank you, Mr. Chairman. 

When it comes to this arcane subject of the Fed’s authority to 

pay interest rates on reserves, I will admit in all candor that I am 

reminded of a couple of Mark Twain’s phrases, one of which was, 

it’s better to keep my mouth shut and allow people to think me ignorant then to open my mouth and remove all doubt. This just 

seems to me to be a question of how many angels can dance on the 

head of a pin. 

But I am heartened by the turn of this conversation which has 

become what is it that we can do to grow our economy at a faster 

rate than the relatively anemic growth that we have been experiencing. That fact not withstanding that I think we are now in our 

74th straight month of private sector employment addition. 

25 

Somebody used the other oft-used phrase earlier: This isn’t rocket science. And when it comes to what it is that increases gross domestic product growth, I don’t think it is rocket science either. If 

you want to increase aggregate demand, here is a real simple formula, this isn’t hard: Increase employment and increase wages. 

Give America a raise, and give more people jobs. And that is 

what we learned in undergraduate school, logic class Tautology, A 

equals A. Why? Because our economy is nearly 70 percent demand 

driven by consumers. 

So, if you want to increase the rate of growth in this economy, 

give more people jobs and increase wages. Voila. 

Now, there has been some reference here, which seems off topic 

to me, with all due respect, to regulatory environment and the like. 

Nobody has talked about the fact that the minimum wage has been 

stuck at $7.25 for I don’t know how many years. 

I would ask every single person sitting in this room, or watching 

or listening, do you want to live on $7.25 an hour? Try that out. 

See what it is like to try to pay your rent and buy your food and 

provide for your children at $7.25 an hour. 

You want to move this economy faster? How about we stop 

underinvesting in our Nation’s public infrastructure? 

In my district, fully 25 percent of the bridges are, from an engineering standpoint, deficient. Do you want to increase the economic 

growth in South Puget Sound and Washington State? Then complete State Road 167 into the Port of Tacoma, which will connect 

the largest warehouse district, the second largest warehouse district on the West Coast; to the largest container port in the Pacific 

Northwest. 

Fortunately, the State Legislature passed a transportation improvement bill to do just that. Bipartisan, but that will increase 

growth. 

You want to increase growth in South Puget Sound? Increase aggregate demand, increase the growth rate of the GDP? Then relieve 

the congestion on Interstate 5, around joint base Lewis McCord, 

also included in this last Transportation Improvement PAC. 

Yesterday morning, I drove from Olympia, Washington to 

SeaTac—52 miles. It took me nearly 2 hours. No accidents. On an 

interstate freeway. 

Ask yourself how much time people are sitting in traffic, moving 

at a glacial pace, not being home with their families for dinner, or 

not getting their goods to market, because we are under-investing 

in public infrastructure. 

Now, if there is one thing this entire Congress—Democrats and 

Republicans, and Liberals and Conservatives—ought to agree on it 

is that 2 percent isn’t cutting it. It is an aggregate-demand economy. 

Let us sit around here, and talk about how many angels could 

dance on the head of a pin, interest rates and excess reserves. But 

if we want to really move this economy forward, if we want to increase the GDP, then we need to increase wages and give more 

people jobs. 

I wish to associate myself with the remarks of the gentleman 

from Connecticut. With that, I yield back the balance of my time. 

26 

Chairman HUIZENGA. The gentleman yields back. With that, the 

Chair recognizes the gentleman from Minnesota, Mr. Emmer, for 5 

minutes. 

Mr. EMMER. Thank you, Mr. Chairman. And thanks to the panel 

for being here today. 

My understanding is we are talking about the tool, as it has been 

referred to, that the Federal Reserve was given as part of some legislation passed in 2008, to pay interest on reserves. 

And that, supposedly, was recommended many years earlier by 

Milton Friedman. But correct me if I am wrong, I don’t think Milton Friedman suggested pay, not only on required reserves, because there is an implied tax, but I don’t think Milton Friedman 

suggested paying interest on excess reserves. Am I incorrect about 

that? 

Mr. SELGIN. I can’t speak to what Mr. Friedman actually said on 

the specifics, but I am sure that he would have argued that it is 

the required reserves that really impose a cost on banks. 

But that is mostly because banks normally hold, in this country, 

very few excessive reserves. And the only way you can get them to 

hold more than a few, is by paying them interest on reserves. 

Mr. EMMER. And let us— 

Mr. SELGIN. On excessive reserves. 

Mr. EMMER. Thank you, Dr. Selgin. Because let us say, if you go 

based on the facts, in 2007 the required reserves averaged $43 billion. Excessive reserves, at that time, averaged only $1.9 billion. 

And with the exception of 2 months in our country’s history, that 

had been the case for 50-some years. 

In fact the case, as I understand it, is the excessive reserves typically accounted for about 10 percent of the total required reserves, 

up until this law was passed. And now, we have this huge balance 

sheet with $4.5 trillion in—the panel has told us that you have 

some ideas of how we are going to correct this. 

Before I leave it, though, Dr. Selgin, I think the important part 

is that the important point you made is not a partisan point. 

It is when you have all of this money sitting on reserve, apparently paying more money that maybe it could get out in the marketplace. You have the government distorting the marketplace, and 

that money isn’t being put to work for better jobs, and higher 

wages, and new opportunities. 

Is that the point you were trying to make? 

Mr. SELGIN. It is. And, again, what is relevant is not the absolute 

amount of reserves, which would go up necessarily. It is the 

amount of excess reserves, and how that has increased. And how 

it has increased in proportion to the overall size of banks’ balance 

sheets. We would take the bank’s balance sheet overall size as 

given. 

The question is, what are they doing with the resources available 

to them? If they are devoting them to holding reserves, then the 

investment is channeled to the Fed, and channeled to the sectors 

the Fed supports. 

If they don’t do that, then they are channeling the investment 

themselves, directly, to other uses; which generally speaking, will 

be more productive. This is a mathematical certainty. 

27 

Mr. EMMER. Dr. Taylor, quickly. And I am sorry about the short 

time, cause I would like to hear this from everybody, but of the different ideas that we have heard of how you reduce this excessive 

balance sheet, you start to rebalance it, if you would. 

By divesting assets, allowing assets to mature and run off these 

different ideas, which one would be the best? And do we risk, if it 

is done improperly, inflation or deflation circumstances? 

Mr. TAYLOR. I think it requires all these things. In addition, I 

would say some selling, some of the securities. In a way that is 

made clear to the markets. So the Fed seems to be worried about 

doing that, but I think you want to go further than, just, let it run 

out to 2029. So, I think that is the most important thing. 

And also, I think, having a goal, that is where they want to go. 

There is this statement about normalization that they have, but it 

is not clear about where they are going eventually. I think that is 

very important so then, people can plan. 

If I just add an example of an analogy. Back when there was the 

controversy about the Taper Tantrum, that is because the thenChair of the Fed wasn’t very clear about what they were doing with 

the balance sheet. 

As soon as they clarified, and this is with the new Chair more, 

it was an easy thing to start, just to have the Taper. It didn’t cause 

disruption. 

I think it is very much the same now, as if they were clear about 

how they would reduce the balance sheet. I long ago argued that 

by the time the Federal Funds rate is at 2 percent, the balance 

sheet should be at the level where that rate is determined by the 

supply and demands reserves. 

I think that is kind of a goal that they could set. It is consistent 

with the tightening that they are planning on. It would be well-understood. I think it would work fine. 

Mr. EMMER. Thank you. I see my time has expired. 

Chairman HUIZENGA. The gentleman’s time has expired. With 

that, the Chair recognizes the ranking member of the full Financial 

Services Committe, Ms. Waters, for 5 minutes. 

Ms. WATERS. Thank you very much, Mr. Chairman. I am very 

pleased about this hearing today. This is just the beginning of a 

long-term debate that we are going to have on the Fed. 

Let me just say that, when we had Federal Reserve Chair Janet 

Yellen here, she made it clear that allowing the Federal Reserve 

to pay interest on reserves as long as there is an abundance of reserves in the banking system, is absolutely critical to its ability to 

gradually and predictively move rates up as warranted, in the current environment. 

Now, I think it is important for me to say, at this point, that I 

have spent considerable time with Chair Janet Yellen, wanting to 

make sure that I understood not only quantitative easing and what 

it had done, and what it had not done, but I was very interested 

in this payment of interest on reserves and excess reserves, as it 

has been alluded to here. 

I have the greatest confidence in her. And I absolutely believe 

that she is making and has made some tremendously important decisions that have been extremely helpful. 

28 

I think there is just a basic philosophical difference between this 

side of the aisle and that side of the aisle on whether or not the 

Fed should be independent, and I absolutely believe in the independence of the Fed and I absolutely believe that what has taken 

place here, particularly with quantitative easing and that program, 

that reduce long term Treasury yields by more than a full percentage point. 

It is important for us to know and understand lower, longer term 

rates also support a strong economic growth, help the stock market 

recover, allow underwater home owners to regain equity in their 

homes, and have positive effects on consumer spending through the 

wealth effect. 

Lower long-term rates also make business investment more affordable and make the trade balance more favorable by lowering 

the value of the dollar. 

So, I am going to turn to you, Dr. Keister. In your assessment, 

would all of these benefits associated with the Fed’s quantitative 

easing program have been achievable if the Fed knew it wouldn’t 

have the ability to manage short-term rates through interest on excess reserves as part of the normalization process? 

Mr. KEISTER. No, absolutely not. The ability to pay interest on 

reserves, including on excess reserves, I think, was critical in encouraging, in allowing the Fed to know that when the time came 

to raise interest rates, it could raise interest rates, regardless of 

the size of its balance sheet. 

And for that reason, it was able to undertake these large-scale 

asset purchases which, as you mentioned, help lower long-term interest rates and increase the flow of credit to consumers and households. 

If I may, I would like to make one other point that I think has 

gotten a bit lost in this discussion. So, Dr. Taylor had emphasized 

that allowing the Fed to pay interest on excess reserves going forward gives the Fed an additional policy tool, which is absolutely 

correct. And then he discussed some ways the Feds could potentially misuse that tool. 

But he also mentioned that the Fed’s response to the early stages 

of the financial crisis in the fall of 2008 was proper. In response 

to a financial panic the Central Bank should do what it, what the 

Fed was chartered to do in the original Federal Reserve Act, that 

is provide an elastic currency, increase the supply of bank reserves 

with a supply of liquid assets when there is plight in the safety of 

the banking system. 

If the Fed were to lose the ability to pay interest on reserves, we 

would be back in the situation we were in, in 2007. The Fed would 

face a conflict between being able to provide liquidity to the market 

in periods of financial turmoil and maintaining the interest rate 

that is appropriate with the stance of monetary policy. 

The Congress accelerated the authorization of the Fed to pay interest on reserves precisely to allow it to arrest the crisis in the fall 

of 2008. But had the Fed had that authority earlier, it would have 

been able to provide a much stronger market-based programs of liquidity assistance which may—it is hard to know for sure—have 

been effective in helping to prevent the worst of the financial crisis 

29 

and thereby, make some of the stronger programs that we saw 

later unnecessary. 

Ms. WATERS. Thank you, very much. I noticed that the word ‘‘experimentation’’ has been used several times here and I think I 

would object to calling the quantitative easing and the interest on 

excess reserves ‘‘experimentation.’’ 

It is flexibility, as I see it, and understand it. And I know that 

Mr. Huizenga has proposed, or is proposing that, somehow, we 

should absolutely bow down to the Taylor Rule, and maybe if there 

is something extraordinary happening, like 2008, we could have 

flexibility. 

So, I know you don’t have time to answer that, but I think that 

is something that should be considered in our discussion as we continue to talk about the independence of the Fed. I yield back. 

Chairman HUIZENGA. The gentlelady yields back. Time has expired. I will point out that is actually not what the format says, 

but that is for another conversation. So with that, the gentleman 

from Indiana, Mr. Stutzman, is recognized for 5 minutes. 

Mr. STUTZMAN. Thank you. Thank you, Mr. Chairman, and it is 

good to see the panel. Dr. Taylor, it’s good to see you, and I have 

enjoyed listening so far to the conversation. 

One of the things that people back home often expect from Washington is that it not stand in the way of progress, that it not stand 

in the way of growth. And if you look at history that we have here 

in this country, and the United States has been blessed with different periods of tremendous growth but you look at what we have 

also seen in the past 10 years. 

I am looking at an article right now that says that the United 

States has record 10th straight year without 3 percent GDP 

growth. And I think that this is only, this is only the way that 

things are going to feel better, be better in the, across the country. 

When you talk to families in Indiana, in the 3rd District, they 

are wondering why things aren’t better. What is standing in front 

of growth? 

And I think there are a variety of things to address that. I think 

it is an interesting thing, too, that while it may not just be Fed policy that affects growth, I think also you see the regulatory environment that we are dealing with out of Washington has slowed 

growth tremendously. Industries just don’t know what to do. 

But I think that when you look at the facts, and if you take a 

macro view of where this country has been over the last 100 years 

with the institution of the Fed, there are two periods in history. 

And I think this is what we all want. We all want to figure out 

what gives us growth, because that is the way the country is only 

going to move forward. That is the way families are going to do 

better. 

And there were two periods in Federal Reserve history when we 

experienced a tremendous amount of growth and that happened to 

be in 1923 to 1928 and then in 1985 to 2003. In the first case, the 

Fed operated under some form of the Gold Standard, and in the 

second case, under the Taylor Rule, more or less. 

And those were two periods where we saw tremendous growth. 

And I think that is what is lost on Washington a lot of times, is 

30 

the fact that families are struggling today, that America could be 

doing a lot better, that we are not reaching our full capacity. 

To go 10 years without 3 percent GDP growth is really remarkable. And I think we all should be asking the question, why? Why 

is that the case? And I know, we all want what is best for families. 

We want what is best for this country, for us to deal with the debt, 

for us to deal with increased wages. 

Something is going to have to give, and I think that this hearing 

is particularly interesting because it deals with the Fed, which I 

do believe affects our economy. 

Dr. Taylor, I would like to start with you about the balance sheet 

of the Fed. Why not just naturally wind it down? What is keeping 

the Fed from winding down its balance sheet and I think that the 

more strength we see, the more opportunity and ability in the private market is going to give. 

I can feel it when I go home. There are people who want to grow, 

but can you talk a little bit about the Fed and just why don’t they 

naturally wind down their balance sheet? 

Mr. TAYLOR. I think they could. I think they are reluctant to, for 

the same reasons; they think the expansion was beneficial and we 

heard a couple of statements about that already. I don’t think it 

was so beneficial. 

To me, they can undo this, as long as it is gradual, certainly they 

can take some time to do it and be clear about it. I think that is 

the way to go. 

I think that there are, as you say, many other things in policy 

and I do think this regulatory reform, I do think the fiscal reform, 

the tax reform, and all those things are very important. They go 

together, to me. 

You mentioned these periods of time. Well, those are periods 

where you also saw good and bad other kinds of policies too, so it 

all goes together in my view. 

Mr. STUTZMAN. I don’t know if anybody else would like to comment. Go ahead. 

Mr. EISENBEIS. Yes. There are really two underpinnings for 

growth. One is for real economic growth, and one is for population 

growth, which contributes to economic growth and the second is 

productivity. 

Productivity has really slacked off and productivity growth has 

slacked off and to me, that is an area where policy focus should be 

as to what is holding back productivity growth at this point. 

Because, on the one hand, we have technology and a lot of things 

in place that look very promising, but why isn’t productivity growth 

expanding? The Fed can create a climate for growth but it can’t 

deal with productivity growth and some of the key underlying determinates of real GDP growth. 

Mr. STUTZMAN. Absolutely. And I agree with that, but again, a 

sound fiscal monetary policy is part—it has to be one of the top priorities for us, especially in this committee, but knowing energy. 

Energy doesn’t know what to do right now because of the policies 

out of Washington. Manufacturing—every time businesses turn 

around, they just feel another sort of regulation piling on them and 

that is what is slowing us down. But for these purposes, the best 

31 

thing we can do is to make sure the monetary policy is fiscally 

sound. Dr. Elgin? 

Mr. SELGIN. Yes. 

Mr. STUTZMAN. If it is okay with the chairman. 

Mr. SELGIN. Let us remember that this is, you can achieve any 

level of monetary policy, any degree of contractionary or expansionary policy with any number of combinations of balance sheet 

adjustment and interest on reserve. 

Unwinding the Fed’s balance sheet is contractionary, other 

things equal. But interest on reserves or raising the rate of interest 

rate, of interest on excess reserves, is also contractionary. If, right 

now, we have a combination where banks are encouraged to hold 

high excess reserves and the balance sheet is very large. 

Now, even if you think that the overall stance of policy is sound, 

that combination implements the stance of policy in a way that involves less productive investment. The alternative is for the Fed to 

have a smaller balance sheet and for interest on reserves to be 

lower so that the demand for excess reserves is lower. 

You can have the same monetary policy stance but end up with 

much more productive activity as a result of more savings being allocated through the private sector banks and fewer through the 

Fed. 

Mr. STUTZMAN. Absolutely. I agree with that and I just think 

that we have to focus on velocity in the economy and this is one 

thing that is slowing down our monetary policies. With that, Mr. 

Chairman, I will yield back. 

Mr. MULVANEY [presiding]. I thank the gentleman. I will now 

recognize the gentleman from Michigan, Mr. Kildee, for 5 minutes. 

Mr. KILDEE. Thank you, Mr. Chairman, and I thank all the witnesses for your participation. 

My question is specifically for Dr. Keister. First of all, welcome, 

and congratulations on a wonderful commencement exercise that 

you had at Rutgers. It got a lot of attention and we welcome, we 

certainly welcome Rutgers to the Big 10. As a Michigan fan, I have 

to tell you, any chance we can have somebody come in to sort of 

slip below our ranking, we are happy to have you. 

Mr. KEISTER. You are welcome. 

Mr. KILDEE. Thank you, and I apologize if my question is redundant or has already been addressed. I was just able to get here to 

the hearing. 

But if I understand the hearing, it concerns the tools currently 

available to the Fed in order to influence short-term rates in particular, paying interest on excess reserves and overnight reverse repurchase operations so, Doctor, in your testimony before our committee in February, in her testimony, Chair Yellen indicated that 

higher rates of interest paid on excess reserves would, in her 

words, eventually pass through to customers in the form of higher 

deposit rates. 

My first question is, what evidence do we see that savers are actually benefitting from the increase in interest the Fed is paying 

on bank reserves in the form of higher deposit rates? 

And I ask this because I think it is important that we take a 

broader view regarding the resources that can be used to invest, 

32 

particularly in distressed communities and cities, which have been 

the focus of a lot of my work. 

I have pushed that the Fed use all of its tools to meet the obligations regarding stable prices but most importantly, I think, particularly in the areas I represent, to maximize employment. So, how 

do you see the Fed’s influence over short-term interest rates impacting its broader goals? If you could address those two questions, 

I would appreciate it. 

Mr. KEISTER. Sure. So first, regarding the evidence that consumers are benefitting from higher rates, the whole goal when the 

Fed raises interest rates, it raises the interest rate currently that 

it is paying on excess reserves and it drags up all market interest 

rates with it. I don’t have specific data handy, but I do have anecdotal evidence. 

I pay attention to the interest rate I receive from my bank, and 

when the Feds raised the interest rate on excess reserves from 25 

basis points to 50 basis points, the interest rate I received went up. 

As I mentioned I looked it up for preparing my testimony. It is 

currently 30 basis points. Okay. So, and as the Fed continues to 

raise, as the economy continues to recover, the Fed finds it appropriate to continue to raise the interest rate it pays on excess reserves. 

Banks will compete for deposits and as they do so, that will bid 

up the interest rate the depositors are receiving. So raising interest 

rate on excess reserve is designed to benefit savers and that will 

happen. Could you repeat your second question? 

Mr. KILDEE. The second question is, what are the implications 

for the Fed’s broader goals, particularly regarding increased employment? In other words, what are the externalities that you see 

in a broader economy resulting from this practice? 

Mr. KEISTER. Sure. So, the Fed is always, in normal times and 

now, trying to balance the competing goals of promoting full employment while keeping prices stable. Okay? And the decisions the 

committee makes on the interest rates are designed with those two 

goals in mind. 

So, as has been discussed here so far, one possibility of removing 

accommodation and that is, restraining the economy as it continues 

to improve, would be for the Fed to shrink its balance sheet. 

I think the Fed has chosen, and Chair Yellen has testified, that 

doing so by shrinking the balance sheet is a less conventional way 

of communicating the stance of monetary policy to markets. 

The more conventional way is to do it by raising interest rates, 

and so the committee has chosen, at least for the time being, to 

normalize monetary policy by first raising interest rates and then 

later, shrinking its interest rate back to, sorry, shrinking its balance sheet back to a more moderate size. 

And in doing so, I think it is making a judgment that is reasonable in my view, that before taking the untested path of shrinking 

its balance sheet, we would like to make sure the economy is on 

a more sound footing and to decrease the risk associated with any 

uncertainty or any market disruptions that could be potentially associated with that. 

Mr. KILDEE. Thank you. My time is just about up. I yield back 

the balance of my time. 

33 

Mr. MULVANEY. Thank you. The Chair will now recognize Mr. 

Schweikert from Arizona for 5 minutes. 

Mr. SCHWEIKERT. Thank you, Mr. Chairman. You look good in 

that chair. Okay. I have a dozen different questions and let us try 

to ramp through them and see if we can make them make sense. 

Mr. Keister, I remember a conversation about 2 years ago that 

the RRP’s sort of mechanics that we were looking at, particularly 

in light of deposit insurance, sort of arbitrage that a bit, that actually you would, in some ways inflate up, long term mortgage rates, 

because you would be, in a sense. Was that what you were telling 

me about your own personal experience on a home loan? 

Mr. KEISTER. That is right. So if I understand correctly, you are 

asking so, as the Feds raised the interest rate on excess reserves, 

it also raised the interest on this new overnight RRP— 

Mr. SCHWEIKERT. Well, yes. It is obviously more than that. You 

have the IOER’s, a pool, take away my deposit insurance, pull that 

out of the market, would you then start to raise up my cost of 

mortgage? 

Mr. KEISTER. That is right. So any time the Fed raises shortterm interest rates, the goal is to be removing monetary accommodation and that should raise longer-term rates. 

Mr. SCHWEIKERT. Okay. Dr. Selgin, there are a couple of things 

I am trying to get my head around. First off, is this sort of system 

we have right now with the Feds dramatically sort of growing the 

way they are compensating excess reserves and sort of that reverse 

repo mechanic? 

Has it started to squeeze out private providers of repo? Because 

now I am competing with the Federal Reserve and I no longer have 

deposit insurance. Are we seeing that? 

Mr. SELGIN. Yes. It is because of the way the Fed repo operations 

work. They actually don’t, they take collateral from the marketplace that is not available even though technically you have shortterm purchases. 

That is, the Fed is borrowing, but it is borrowing in a way that 

doesn’t take the collateral off its balance sheet and make it available to the private sector. 

So, the result is that there is a shortage of collateral for other 

kinds of credit creation, including private repo operations. And this 

is a big problem. 

Mr. SCHWEIKERT. Dr. Eisenbeis, please. 

Mr. EISENBEIS. Actually, what the Fed is doing is repoing its own 

securities out into the marketplace. So, the securities actually become a liquid asset that can be repoed out, or used as collateral for 

other activities. So what is supplying liquidity in the market, in 

terms of— 

Mr. SELGIN. Not true. 

Mr. EISENBEIS. —the securities. 

Mr. SELGIN. No. 

Mr. SCHWEIKERT. But— 

Mr. SELGIN. No. 

Mr. SCHWEIKERT. —even in that case, all you are doing is functionally saying, hey, I already hold the asset. That is my pledge on 

the repo. You are— 

Mr. EISENBEIS. What it is doing— 

34 

Mr. SCHWEIKERT. —basically just pulling that cash out. 

Mr. EISENBEIS. What it is doing is sterilizing part of the excess 

reserves. 

Mr. SCHWEIKERT. Yes, but that doesn’t leave you any multiplier 

effect in— 

Mr. EISENBEIS. No, it doesn’t. 

Mr. SCHWEIKERT. —in the least light. 

Mr. EISENBEIS. No. 

Mr. SCHWEIKERT. And that was part of the, where I was going 

to go with. It is this, okay, fine. I get to use my existing book, I 

get to pledge it up, I get my repo. 

But if you are having an argument saying, okay, where is my liquidity, my expansive monetary policy, you are actually, in some 

ways, doing just the opposite. 

Mr. EISENBEIS. No, it is designed to raise interest rates. It is the 

tools that sort of tighten policy, in that sense. 

Mr. SELGIN. They are, if I may say— 

Mr. SCHWEIKERT. No. 

Mr. SELGIN. Sorry. 

Mr. SCHWEIKERT. Sorry. 

Mr. SELGIN. The— 

Mr. SCHWEIKERT. And tell me if I was wrong in my— 

Mr. SELGIN. No, you are not. 

Mr. SCHWEIKERT. —feeble attempt to explain. 

Mr. SELGIN. You have to understand, there are two ways interest 

ways can be raised. Doctor Keister referred to tightening money, as 

a way of raising interest rates; which it certainly will do in the 

short run. 

But the overwhelming reason for low interest rates right now is 

the low level of GDP in overall nominal spending. And that has a 

contractionary effect and interest on reserves contributes to that. 

But if we avoid spending by creating more liquidity, instead of 

increasing the demand for liquidity, that too will eventually put upward pressure on interest rates, but in a way that doesn’t involve 

overall tightening of— 

Mr. SCHWEIKERT. Okay. 

Mr. SELGIN. —credit. 

Mr. SCHWEIKERT. This is one of those moments I definitely wish 

I had more time. 

Dr. Taylor, I need help on two things, and you have like 10 seconds to do it. If I come to you and say, the size of the book as it 

is today on the Federal Reserve, what does that do to lending velocity in the overall economy, when my safe yield rate is, I basically, 

I have a free, or safe rate with a yield. 

So, my cash ends up going into the Federal Reserve, instead of 

multiplying in the economy. And next—no, let us do that because 

we are out of time. So— 

Mr. TAYLOR. I think in that case, these excess reserves are, if 

anything, signaling that they are going to be there for a while. So 

there is this notion they are going to there for a while, and therefore, we are not going to be back to normal for a while. 

And I think that is a problem with its effects on the economy. 

That is the main thing I would say about that. 

35 

Mr. SCHWEIKERT. I couldn’t find it, but somewhere I have an article about the allocation of capital argument. That one of the problems for our lack of growth is— 

Mr. TAYLOR. Yes. 

Mr. SCHWEIKERT. —we are not getting the allocation in— 

Mr. TAYLOR. I think in the— 

Mr. SCHWEIKERT. —places in the economy— 

Mr. TAYLOR. —Federal. Certainly in the money markets. 

Mr. SCHWEIKERT. —where, yes you might have a little risk; but 

you get a— 

Mr. TAYLOR. Yes. 

Mr. SCHWEIKERT. —multiplier. 

Mr. TAYLOR. That is it. 

Mr. SCHWEIKERT. Is this the— 

Mr. TAYLOR. That is a— 

Mr. SCHWEIKERT. —cost. 

Mr. TAYLOR. Certainly in the money markets they haven’t been 

functioning very well at all. Maybe they will as the rates come up 

a little bit, but that is an allocation of those funds to different 

banks and different parts of the economy, which is not very effective, with the near zero interest rate. 

Mr. SCHWEIKERT. All right. Mr. Chairman, thank you for your 

patience. I yield back. 

Mr. MULVANEY. I now recognize the gentleman from New Mexico, Mr. Pearce. 

Mr. PEARCE. Thank you, Mr. Chairman. 

If the gentleman from Arizona needs a little bit more time, I 

would be happy—I was going to follow right along in that line of 

questions if you— 

Mr. SCHWEIKERT. Maybe, keep going— 

Mr. PEARCE. Okay. So, this idea that we are encouraging, Dr. 

Keister, this is kind of at odds with your testimony. But it is something that I believe in real life that we are giving incentive for 

banks to hold reserves, rather than getting the money out to where 

it starts causing the economy to grow. 

You appear to approach it from a little different point of view. 

Can you explain why that perception that you have been hearing 

is now, and is definitely rooted in my mind, is maybe incorrect? 

Mr. KEISTER. Sure. So, it is important to keep in mind that when 

the Federal Reserve creates reserves, as Dr. Eisenbeis mentioned 

earlier, they don’t disappear. So the quantity of reserves in the 

banking system is going to be there. No matter how much lending 

goes on, and other activity. Okay? 

So when the Federal—and also when, as I testified earlier, when 

the Federal Reserve creates reserves, that process also creates 

bank deposits. So banks are getting a new source of funding, at the 

same time that they are getting a new asset. 

So, that funding, that new asset is not crowding out other things 

they—other assets they could be holding. Loans to businesses, 

loans to consumers. 

Mr. PEARCE. Yes, see I would perceive it exactly the opposite, 

that a bank is sitting here with its reserves, and they have to tell 

us what to do with them. If they don’t have that return on that 

36 

investment, then they are sort of forced to do what banks are supposed to do. 

But I think now then, a lot of banks are just sitting on reserves. 

I don’t think they are out there, because I hear the small business 

people coming and saying, well, I have pretty good credit. I have 

never missed a payment, but I can’t get a loan. I want to expand 

my business. And so, the banks are being given an incentive to 

stay out of the business of loaning money, and so, yes, I didn’t 

quite— 

Yes, sir, Dr. Selgin. 

Mr. KEISTER. Well— 

Mr. PEARCE. Selgin. The other seat, go ahead. You seem to want 

to make comments, so I am going to— 

Mr. SELGIN. Yes I do. Thank you. It is true that when the Fed 

creates reserves, it creates an equal amount of deposits in the system. 

But it is also true that in the absence of interest on reserves, 

conventionally and before the crisis, the total deposit creation, because of the lending of the extra reserves, that is of the excess; 

would end up being something like 10 times the initial creation associated with the Fed’s own expansion. 

So, what happens in the interest on reserves, on excess reserves 

environment, what has happened, is that multiple of 10 has gone 

away. And this is why, as a ratio of their total balance sheets, the 

banks, end up holding a much higher than they normally do. 

It is the ratio that is determining the relative extent of productive investment that goes on. And that ratio of productive investment to reserves is what is down. Banks have control over that. 

If they didn’t have control over the ratio, why in other cases 

where central banks have created vast amounts of reserves, you 

would see reserves—excess reserves accumulating, instead of banks 

lending more. Every hyper-inflation we have ever seen would have 

been impossible, because the banks would have just sat on their reserves. 

Mr. PEARCE. Okay. Wait. 

Mr. SELGIN. So it is not true that banks have no choice. 

Mr. PEARCE. So, if we are going to follow on, and we want to add 

another variable into it. So now then, you get regulators. You consider that, okay. Maybe the interest has an effect, maybe it doesn’t. 

But when you get regulators coming in, and looking at the bank, 

and saying, about fairly safe loans, that we are going to classify 

this loan. So now then, you have just the suggestion, says, I am 

better off being on the sidelines because the regulatory impact of 

very good loans—again, these are loans that I have heard about in 

our district, where people say, why would I ever lend money? When 

the regulators are going to say this, and they will pay me not to 

lend money. 

And so, in a State like New Mexico, with a small economy, we 

have 70 days’ worth of funds to lend for houses. So, it is not like 

the State is swimming in cash reserves. 

And yet, we are giving these depressing effects. So we have not 

seen that dramatic economic growth that is being proclaimed here 

in Washington that is occurring. 

Dr. Taylor, do you have an observation? 

37 

Mr. TAYLOR. Yes. I think during this period where they had a 25 

basis points interest on reserve, it is really in retrospect I think. 

Dr. Selgin is correct about this. In retrospect, I would say, why did 

they do that? 

I think Dr. Kiester is saying, well, they were doing that because 

they wanted to move to ready to move it from 50 basis, from 25; 

which is not clear why they had to do that. 

So, I think, a lot of these questions wouldn’t be there, had they 

just not paid interest rates on reserves. They had the right to do 

that, obviously. It doesn’t mean they have to pay interest. They 

could have paid zero, starting back in 2008 until now, until December of 2015. 

I think, in retrospect, it certainly would have been a better thing 

to do. They have given lots of answers to that to people over the 

time, I am sure. I think the main one is to be ready. The mechanism is there. I think it is questionable. 

Mr. PEARCE. Yes, and then just then a last point that, and 

thanks, Mr. Chairman for a little bit of the time here, but the 

banks, a little bit, get out of the perfection of making good loans 

versus bad loans. 

And so, they are uncertain because their activity has shrunk 

down, due to regulatory things, and cash reserves are being really 

encouraged. And so, I find that the banks even get a little out of 

practice, in determining what is a good loan and a bad loan. 

And then, they are even more hesitant, at a time when we need 

them to be more courageous. They are more hesitant, and the economy suffers. 

Thank you, Mr. Chairman for your indulgence. 

Mr. MULVANEY. I thank the gentleman. And while we are not 

going to do a second round, Ms. Moore was very gracious in allowing me to maybe ask just a few more questions to finish up on 

some of our dialogue earlier, Dr. Selgin. 

To refresh your recollection, we were talking about the Fed not 

marking to market the balance sheet implications of the value of 

their assets, and so forth. And then you made a comment as the 

time was expiring about the P & L, the profit and loss impacts of 

that. 

And whether or not if their earnings, the net earnings, turned 

negative, they might have to come hat in hand to Congress. I had 

actually asked Dr. Bernanke that question along those lines 2 

years ago. 

Where in a rising interest rate environment, you can foresee a 

situation where the net earnings of the Fed go negative. That they 

will have to end up paying off much higher rates of interest, they 

won’t be earning as much on their balance sheet, et cetera. 

And I asked him, what would happen? And he did not say that 

they would have to come hat-in-hand to Congress to ask for money. 

He said they would simply take it off the balance sheet, or adjust 

the balance sheet. 

I never really understood exactly what he was talking about. I 

got the impression what he meant was, they were going to conjure 

the money up, the same way they do to buy. Dr. Eisenbeis is saying 

no. 

38 

Dr. Selgin is looking at me, like, he is not sure what I am talking 

about. I am just curious to know, what might happen in a situation 

where the profit and loss turns negative for the Federal Reserve? 

We will start— 

Mr. EISENBEIS. I have— 

Mr. MULVANEY. —with Dr. Eisenbeis. 

Mr. EISENBEIS. I have the answer to that. 

Mr. MULVANEY. And then go to Dr. Selgin. 

Mr. EISENBEIS. I have the answer to that, sir. According to the 

way the law is set up, when the Fed income is no longer sufficient 

to pay interest on reserves, they stop making remittances, and 

write the difference up in this negative asset account that I was 

talking about before. 

And what that is, is an acclaim on future revenues on Treasury 

securities, and assets on the balance sheet that as it is received, 

would be used to write down that account, and when it can borrow 

from the— 

Mr. MULVANEY. To borrow from their own future earnings— 

Mr. EISENBEIS. Yes. 

Mr. MULVANEY. —is what I have—and something that private 

business can’t do, right? 

Mr. EISENBEIS. No. Actually, there is the loss carryforward, but 

it is not really, totally analogous to this. 

Mr. MULVANEY. I have never been able to monetize a loss carry 

forward. I have news for you, it is hard to do, but— 

Mr. EISENBEIS. The Fed can do it, however. But it is really, sort 

of, an accounting gimmick. To sort of preserve, and enable the Fed 

not to have to go to the Treasury. 

Mr. MULVANEY. It is not that common because it has never happened, right? The Fed is never— 

Mr. EISENBEIS. No. 

Mr. MULVANEY. Okay. 

Dr. Selgin, are you, in general, accord with that? 

Mr. SELGIN. Yes, you can do that up to a point. Remember that 

the interest payments that have to be made to the bank exceed the 

terms, then it is losing money. In that case, there has to be some 

monetization involved in order for—it has got to be covered somehow. 

Mr. MULVANEY. It does have to be covered somehow. But my understanding is that they can—they can monetize these future earnings to this negative asset account. And, essentially, they have to 

have cash. Because the cash has to go out the door. 

Mr. SELGIN. That is it, that’s right, there is monetization involved, and that is essential, and— 

Mr. MULVANEY. —and it is self-monetization, essentially conjuring the money up, correct? 

Mr. SELGIN. That is right. 

Mr. MULVANEY. Dr. Keister? 

Mr. KEISTER. I would just like to add one point. So, this possibility we are discussing is the flip side of the larger emittances the 

Fed has been making to the Treasury over the past few years. 

The entire problem could be avoided if the Congress authorized 

the Fed to hold—to create a reserve fund to hold back some of 

39 

these larger emittances, until it is able to shrink back its balance 

sheet, and this possibility has disappeared. 

Mr. MULVANEY. That is a fascinating idea. It sounds like a great 

way to solve the GSE problem. 

Dr. Eisenbeis, did you have one last thought on that? 

Mr. EISENBEIS. Yes. In fact, the opposite has happened because the Fed surplus in the Highway Transportation bill, $20 billion of 

it was taken off the Fed’s balance sheet. 

So, now they have only $30 billion in equity, combination of paidin surplus and everything. So— 

Mr. MULVANEY. I think that was noted, wasn’t it, on one of Ms. 

Moore’s earlier graphs as an additional remittance during last 

year. 

So, if there are no further follow-ups on that specific topic? Ms. 

Moore, do you have anything else? 

Ms. MOORE. No, it was a good question. 

Mr. MULVANEY. I appreciate the ability to ask that question. 

Mr. EISENBEIS. Mr. Chairman, may I make just another clarification? And it has to— 

Mr. MULVANEY. I will stay as long as Ms. Moore wants to. 

Mr. EISENBEIS. It relates to why the Federal funds, effective Federal funds rate was below the target. And the reason was because 

Freddie Mac and Fannie Mae were not able to hold and earn interest on their deposits at the Fed. 

So, they were accumulating large amounts of excess funds, and 

lending them out into the Federal funds market, willing to take a 

rate below the target rate because they had no other alternative. 

And that is the reason the effective funds rate was below the target. 

Mr. MULVANEY. Fascinating. Ms. Moore, do you have anything 

else to add? 

Ms. MOORE. I thank all of the witnesses for your indulgence, and 

we learned a lot. 

Mr. MULVANEY. The Chair notes that some Members may have 

additional questions for this panel, which they may wish to submit 

in writing. Without objection, the hearing record will remain open 

for 5 legislative days for Members to submit written questions to 

these witnesses and to place their responses in the record. Also, 

without objection, Members will have 5 legislative days to submit 

extraneous materials to the Chair for inclusion in the record. 

Thank you. The hearing is adjourned. 

[Whereupon, at 12:03 p.m., the hearing was adjourned.] 

(41) 

A P P E N D I X 

May 17, 2016 

42 


24067.001

Ranking Member Waters Statement 

Monetary Policy and Trade 

Subcommittee hearing titled "Interest on 

Reserves and the Fed's Balance Sheet" 

(2 Minutes) 

Thank you Chairman Huizenga and 

Ranking Member Moore for organizing 

today' s hearing. 

As we look at the Fed's implementation 

of monetary policy in the post-crisis 

1 
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24067.002

environment I think it's important to look at 

the circumstances that have brought us to 

this point. 

In 2008, the Federal Reserve had to take 

unconventional steps to stabilize the 

economy and temper the devastating effects 

of the financial crisis. Fortunately for the 

American people, the Fed's approach 

softened the severity of the crisis, shortened 

2 
44 


24067.003

its duration, and put us on the road to 

recovery. 

Today, the Fed faces a new set of 

challenges. To safely return to its normal 

role guiding monetary policy, while being 

careful not to harm the US economy, the 

Fed must rely, again, on new tools, 

specifically paying interest on reserves. 

3 
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24067.004

While I initially raised concerns with this 

approach, after exploring this matter further 

and speaking at length with Chair Yellen, it 

has become abundantly clear that the net 

benefits to the public that result from this 

policy are substantial. 

Without the ability to directly affect rates 

through the payment of interest, and unwind 

its interventions, the Fed would have to 

4 
46 


24067.005

engage in dangerous fire sales of the assets 

on its balance sheet that would threaten our 

recovery and cost taxpayers dearly. 

I hope that as our Committee conducts its 

oversight, we keep these salient facts in 

mind. 

Thank you, I yield back. 

5 
47 


24067.006

For release on delivery 

!O:OOAM EST 

May 17,2016 

Statement by 

Dr. Robert A. Eisenbeis 

Vice Chairman 

Cumberland Advisors 

Sarasota, Florida 

before the 

Subcommittee on Monetary and Trade Policy 

of the 

Committee on Financial Services 

U.S. House of Representatives 

May 17,2016 
48 


24067.007

Chairman Huizenga, Ranking Member Moore, and other members of the committee, I am 

honored to have the opportunity to testify today and share with you my views on several issues 

concerning the payment of interest on reserves (IOER) by the Federal Reserve System. I will 

focus some of my remarks on the role that IOER has come to play in the implementation of 

monetary policy since the Great Recession. But first I want to address certain misconceptions 

about the Federal Reserve's balance sheet, the role that reserve creation has played in the 

expansion of that balance sheet, and the payment flows among the banks that hold reserves, the 

U.S. Treasury, and the Federal Reserve. 

The Fed Is a Government Entity, Not a Bank 

Before I get to the issue of interest on reserves, I want to address a misperception many 

have on the proper way to view the Fed's balance sheet. First, though the Fed is often compared 

to a private sector bank, that analogy simply doesn't hold up and leads to a number of faulty 

conclusions. There are fundamental differences between the Fed and private sector banks, 

because the Fed is a government entity whose liabilities are both explicitly and implicitly 

guaranteed by the government. As the Fed began its asset purchase program, it didn't go out into 

the market and pay interest on reserves to attract funds as a private sector bank would to gain 

deposits and other sources of funding. Instead, in order to purchase Treasuries, it paid for them 

by increasing the seller bank's reserve account, and it did not first have to raise the funds to do 

so. Had the Fed paid for those Treasuries with currency in the fonn of Federal Reserve notes, we 

would have said that the Fed printed money and monetized Treasury debt. The Fed could have 

made the same asset purchase if the interest rate on reserves (IOER) had been zero, and the Fed's 

balance sheet would be the same size that it is today. 

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24067.008

Second, it is also important to understand that, unlike deposits at a private sector bank, 

reserves never leave the Fed. A bank can't withdraw its reserve deposits from the system the way 

a bank depositor can withdraw funds from his or her bank. When a bank or one of its customers 

engages in a transaction, a reserve deposit moves from one organization to another, ownership of 

a reserve deposit changes, but the funds never leave the Fed. This is true whether the dollar 

transaction is domestic or foreign. Even if a bank were to surrender a reserve deposit for 

currency, the Fed's balance sheet would remain unchanged in size. The Fed's liability in the 

form of bank reserves would go down, but its liability in the form of Federal Reserve notes 

outstanding would go up by the same amount- there would be no impact on the overall size of 

the Fed's balance sheet. 

The Fed can shrink its balance sheet only by selling assets (which reduces the Fed's 

Treasury holdings and also reduces bank reserves) or by allowing its assets to mature and not 

replacing them. In the latter case, the Fed's assets decline, and its liabilities to the Treasury also 

decline. 

How to Think About Interest Payments on Reserves 

Now, what about those interest payments on reserves? Remember that the Fed is paid 

interest by the Treasury on its portfolio holdings (and by Freddie and Fannie, also essentially 

governmental entities at this point). The Fed extracts its operating costs, including the interest it 

pays on reserves, and returns the remainder to the Treasury. If this intragovemmental funds 

transfer between the Fed and Treasury were settled the way interest rate swaps are settled by 

netting, there would always be a net payment from the Treasury to the Fed. 1 Thus, since the 

Treasury is covering the Fed's operating costs and interest payments, it is a misnomer to suggest 

that the Fed is making a profit. 

1 For simplicity, I am including Freddie and Fannie and their liabilities as part of the government here as well. 

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From the perspective of the consolidated Fed-Treasury balance sheet, Fed asset purchases 

of Treasuries merely replace one form of government debt with another, extracting long-maturity 

Treasuries held by the public from the market and substituting a very short-duration demand 

liability in their place. Fed purchases take higher-cost Treasury debt off the market and replace it 

with another form of government short-term demand debt paying 50 basis points. This 

effectively retires securities that were purchased and reduces the cost of debt to the Treasury by 

the difference between the 50 basis points that is paid on reserves and the coupon rate of the 

purchased Treasury securities. This transaction also means that Treasury is currently making the 

50-basis-point payment on bank reserves instead of the higher-rate payment it would have made 

on the Treasuries the Fed took off the market. Otherwise, Fed remittances would be higher by the 

amount of the interest paid on reserves, and the net transfer of funds from the Treasury to the Fed 

would be lower. Moreover, it is only by a quirk in government accounting that the Treasury can 

count remittances from the Fed as revenue for budget purposes. This is clearly a case of 

questionable accounting and is misleading when it comes to the treatment of government 

revenues. 

Are Interest Payments to the Fed a Subsidy to Banks? 

Is it correct to view the interest payments on reserves as a subsidy to banks? We have 

already established that the purchases could have been made even if the payment of interest on 

reserves was zero. So those interest payments surely look like a subsidy. Why not cut the rate to 

zero and thus reduce the financing costs to the Treasury to zero on those reserves? 

The answer lies in understanding how IOER works. IOER is now one of a suite of 

operational tools that the Fed has adopted since the Great Recession for the conduct of monetary 

policy. These tools include not only the IOER but also the reverse repo rate, the term deposit 

4 
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rate, the discount rate and, to a lesser extent now, the target Fed Funds rate. The target Fed Funds 

rate was the main tool the Fed used prior to the recent crisis to influence short-term interest rates 

by setting the rate banks paid to borrow and lend excess reserves in the interbank overnight 

market. This market has essentially dried up now because the huge volume of excess reserves 

has eliminated the scarcity of that asset as far as banks are concerned. The other tools, which I 

am sure others on the panel today will discuss in much more detail, evolved to provide secured 

access to short-term funds, and in the case of the reverse repo market for example, to a wider 

range of counterparties that were not able to access the Fed Fuuds market directly or could not 

hold reserve balances at the Fed.2 

In the wake of the Great Recession, IOER has become an essential tool for the Fed to 

influence short-term interest rates and inflation. For most of the history of the Federal Reserve, 

no interest was paid on reserves. But requiring banks to hold a portion of their assets in the form 

of a non-interest-bearing reserve against their deposits effectively reduced bank earnings and 

functioned as a tax. As a result, many banks opted out of the Federal Reserve System, and the 

Fed even resorted to providing free payments services (the equivalent of free toasters) to offset 

the ongoing cost of membership. 

Predictably, banks sought to minimize excess reserves, and one way to do that was to 

make loans, converting excess reserves into required reserves. For the banking system as a 

whole, this practice creates a money multiplier and expands the money supply, and during 

periods of rapid expansion it leads to inflation. Today, for example, one dollar of reserves could 

theoretically support a tenfold increase in the money supply and potentially trigger an explosion 

in inflation. This unwelcome prospect explains why economists and some members of the 

2 These counterparties include commercial banks that aren't primary dealers (both foreign and domestic), GSEs, and 

money market funds. Freddie and Fannie may hold reserve deposits at the Fed but may not receive interest on those 

funds. 

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FOMC are concerned that the Fed needs to wind down its portfolio, decrease the amount of 

excess reserves, and return interest rates to normal. 

In this context, the Fed's ability to pay interest on reserves is critical to reducing the 

opportunity cost of holding excess reserves. Moreover, it can help significantly to keep interest 

rates, the money supply, and inflation under control, consistent with the Fed's dual mandate. To 

be sure, the payment of interest on reserves will go up as policy normalization proceeds, but 

what is relevant from the government's fiscal perspective is the spread between the market rate 

on Treasuries in the Fed's portfolio and the rate paid on reserves. 

An additional complication arises when we recognize that ownership of excess reserves is 

not evenly distributed across the banking system according to bank size, as we might guess. A 

substantial portion of excess reserves arc held in U.S. subsidiaries and affiliates of foreign banks. 

Figure 1 shows the proportions of reserves and deposits in foreign institutions and how those 

proportions have evolved under Dodd-Frank and as the Fed embarked upon its quantitative 

easing policies. These institutions now account for 40% of the excess reserves (the figure has 

been as high as 50%), but they account for only about 10% of deposits. Because of this 

imbalance, they also receive a disproportionate share of the interest payments on reserves 

relative to domestic institutions. 

There are two explanations for the imbalance. First, the Dodd-Frank Act changed how 

the deposit insurance assessment is charged. Large banks (mainly those over $500 billion) now 

pay more than 15 basis points on total assets. This means that, while they currently earn 50 basis 

points on their reserves, their net return is 35 basis points. (It was 10 basis points prior to the Fed 

rate change in December 2015.) In contrast, since foreign banks are not subject to the 15 basis 

point FDIC assessment, they are able to earn a full 50 basis points on their excess reserves. But 

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for foreign institutions headquartered in Europe or Japan, for example, where policy rates are 

negative, the spread between their domestic rate options and the holding of reserves at the Fed is 

even wider. For a European bank, this spread is now 90 basis points. Such a bank can potentially 

borrow from its central bank at 25 basis points, or lower, and deposit the funds at the Fed to earn 

a risk-free 50 basis points at a positive spread. As an additional bonus, reserves held at the Fed 

by foreign banks count towards their liquidity coverage ratio (LCR) under the Basel III 

requirements. 

These foreign institutions are not likely to intermediate those reserves, nor are foreign 

banks a threat to suddenly engage in explosive lending in the U.S. This feature, while clearly 

providing a risk-free arbitrage to foreign institutions, helps to sterilize some 40% of excess 

reserves, and the impact only increases either as their central banks lower rates even further or as 

the Fed raises rates. 

How Difficult Is the Process Facing the Fed in Reducing Its Balance Sheet? 

The Fed faces a challenge managing short-tenn interest rates with its basket of tools and 

returning its balance sheet to a new equilibrium. If, as argued earlier, excess reserves are 

suddenly employed to support an explosion of lending, then the Fed is at risk of being behind the 

curve in achieving its inflation objective. The Fed has essentially only two options when it comes 

to reducing the size of its balance sheet. It could start the normalization process by not 

replenishing assets as they mature and let that process shrink the balance sheet while it 

simultaneously attempts to control short-term interest rates. Alternatively, it could start selling 

assets in addition to letting existing maturing assets run off. Each of these options involves 

different issues and will be considered in turn. 

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Option 1: Stop Reinvesting 

If the Fed were to stop reinvesting, how long would it take for the balance sheet to reach 

equilibrium? By equilibrium I mean that the portfolio shrinks to a size that its Treasury holdings 

mainly backs the outstanding currency. Since nominal GDP today is much higher than it was 

before the onset of the crisis (when the Fed's balanee sheet was $870 billion), equilibrium 

portfolio size today would be about 7.25% of nominal GDP, or $1.350 trillion. That number 

would grow over time at the rate the economy expands, further mitigating the extent that the 

portfolio needs to shrink from its present $4.4 77 trillion size. 

The speed with which the Fed could let the portfolio run off and the amount of excess 

reserves that would then have to sterilized depends both upon the rate of growth of nominal GDP 

and upon the maturity structure of the portfolio, which presently consists of various maturities of 

Treasury obligations totaling $2.4 trillion and largely IS-year and 30-year MBS. The maturing 

process is therefore heavily concentrated in Treasuries during the early years. Not rolling over 

maturing issues would free liquidity in the Treasury market, if the Treasury reissued securities to 

the public. But the shrinkage would impact the ability of the Fed to engage in reverse repo 

transactions unless the transactions employed agency MBS, which might or might not be as 

attractive as collateral. Assuming a 4.5% rate of growth in nominal GDP (2.5% real and 2% 

inflation), Figure 2 shows that maturing assets alone are not sufficient in the short run to quickly 

restore equilibrium. The volume of excess reserves that would have to be sterilized is substantial, 

and the portfolio would not achieve equilibrium until2029. The scope of the challenge means 

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that some fonn of asset sales or perhaps a higher-than-desired interest rate policy would likely 

have to be pursued. 3 

Option 2: Sell Assets in Addition to Allowing Maturing Issues to Run Off 

The foregoing analysis suggests that some form of asset sales will probably have to be 

employed as a supplemental measure while the Fed's portfolio is being restored to equilibrium. 

Again, this strategy raises additional consequences to consider. First, despite the Fed's reluctance 

to engage in sales of its MBS assets, there actually aren't sufficient assets in the portfolio that 

could be sold in order to achieve equilibrium. Assets in addition to Treasuries would have to be 

sold. Second, the problem with asset sales in general is that the Fed has booked its purchases at 

face value. Should interest rates rise, the market value of those assets would decline, so that asset 

sales would then take place at a loss, which would have to be booked. Given the duration of the 

Fed's assets and capital, I estimate that it would take less than a 20 basis point increase in 

interest rates across the board essentially to make the Fed's portfolio market value insolvent. 

This means that the Fed has virtually no flexibility to sell assets without wiping out its capital. 

Federal Reserve accounting conventions anticipate the possibility that asset sales might 

give rise to losses greater than income. Normally, such losses would be recognized against 

capital, but Fed accounting rules state that such losses would not have to be written down against 

the Fed's equity. Rather, the Fed would create a deferred (or negative) asset account, similar to 

3 The Fed would also have to have sufficient holdings of Treasuries to meet the statutory requirement to back 

outstanding currency. MBS might have to be liquidated or swaped to accommodate this requirement. 

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an accounting mechanism used by some companies accounting for loss carry forwards. 4 Asset 

sale losses would be booked into that account, and future portfolio earnings would be used to 

write down those losses before remittance could be resumed. 

Impending Risks 

The potential costs and reputational risks that asset sale losses pose to the Fed are 

twofold. First, Fed insolvency becomes totally transparent when the deferred asset account 

exceeds the Fed's capital. While economists might argue that book insolvency is irrelevant to the 

Fed since it is part of the government and is ultimately backed by U.S. taxpayers, we must 

wonder what the world's reaction would be to the insolvency of the world's most prestigious 

central bank. 

Second, Congress recently exacerbated the problem at hand when it raided the Fed's 

surplus account and cut dividends to regional reserve bank stockholders in the December 

Highway Transportation Act. Congress reduced the Fed's capital and surplus by $20 billion and 

capped its future surplus at$ I 0 billion. Consequently, the Fed's total capital on account is now 

only $30 billion. Moreover, as the economy and the Fed's balance sheet grow in tandem, Fed 

leverage will increase and so will its risk of insolvency. Taking the surplus amounts to printing 

money to finance highway construction. That is, the actual transaction involves writing down 

the Fed's surplus account and increasing the Treasury's balance at the Fed. When the funds are 

spent, a reserve account is created and the Treasury's balance declines. This amounts to printing 

4 See Carpenter, Seth, Jane Ihrig, Elizabeth Klee, Daniel Quinn, and Alexander Boote, "The Federal Reserve's 

Balance Sheet and Earnings: A Primer and Projections," Board of Governors of the Federal Reserve System, 

January 2013. "The deferred asset is subsequently realized as a reduction offuture remittances to the Treasury 

(which are accounted for as interest on Federal Reserve notes expense). Thus, it is an asset in the sense that it 

embodies a future economic benefit that will be realized as a reduction of future cash outflows. If the realization of 

the asset is expected to occur over several years~ some valuation technique~ such as net present value, would be 

applied to measure the value of the asset. This accounting treatment is consistent with U.S. GAAP and is similar to 

the way that private companies report deferred loss carry forwards as an asset." 

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money to finance government projects. Gimmicky accounting has conjured the illusion of 

providing funding for fiscal projects without paying the true costs. In the process, Congress may 

have damaged the Fed's ability to do its job. 

Conclusion 

In closing, I want to reiterate some of the key points I've made today. First, when we 

think about the Fed, it is important to consider it as part of the government and not a private 

sector entity, despite its unusual structure. Second, the Fed can't make a profit. Rather, it issues 

one form of government debt for another. It receives interest payments from the government, 

takes out its operating costs, and returns the remainder to the Treasury. On balance, there is 

always a net payment from the Treasury to the Fed, and it is inappropriate to consider 

remittances as income for budget purposes, as is the present practice. Third, it follows that 

interest on bank reserves is really a payment from the Treasury to the holders of bank reserves 

a demand liability. Fourth, the ability to pay interest on reserves functions as an important tool of 

monetary policy and should not be viewed as a mere subsidy, just as interest payments on 

Treasury.debt are not regarded as a subsidy. IOER will be needed to play a key role in sterilizing 

bank reserves as the Fed begins to wind down its balance sheet. Further, IOER will be a critical 

tool the Fed can use to avoid having to liquidate assets at a loss. Finally, Congress should 

reevaluate its policy towards the Fed's surplus and capital. 

ll 
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Figure 1. Percent ofTotal Bank Reserves and Domestic US Deposits Held 

by Foreign Banking Institutions 

13inkm~ 

$;',0'.00 

IIIJlll 

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Interest on Reserves 

Todd Keister 

Professor of Economics 

Rutgers University 

Testimony before the Subcommittee on Monetary Policy and Trade 

Committee on Financial Services 

United States House of Representatives 

Mayl7,2016 

Chair Huizenga, Ranking Member Moore, and members of the Subcommittee on Monetary 

Policy and Trade, thank you for inviting me to testify at this hearing on "Interest on Reserves and 

the Fed's Balance Sheet." 

The ability to pay interest on the reserve balances that banks hold on deposit at the Federal 

Reserve is an important policy tool, and Congress' authorization of these payments in the 

Financial Services Regulatory Relief Act of2006 was a welcome development. In the aftermath 

of the financial crisis of 2008 and the subsequent recession, the Fed has come to rely more 

heavily on this tool than was previously anticipated. At the same time, because paying interest on 

reserves is still relatively new in the U.S., there is naturally some uncertainty in the minds of 

both the public and policy makers about the implications of this policy. The issue is particularly 

pressing given the unprecedented level of bank reserves that have been created by the Fed's 

quantitative easing policies. 

In my comments today, I will focus on several points that I believe are crucial for informing 

policy decisions related to interest on reserves. I have chosen these points, in part, because I 

believe they are often either misunderstood or not fully appreciated in the discussion of these 

issues. I will argue that continuing to allow the Fed to pay interest on bank reserves is not only 

essential for the implementation of monetary policy, but also sound economic policy with no 

significant cost to the taxpayer. 

Most of my comments will focus on the payment of interest in excess reserves, since that issue 

has received the most attention in previous hearings. I will also comment briefly on the payment 

of interest on required reserves toward the end of my testimony. 

I have organized my comments around eight key points. 

1) The Federal Reserve's paying of interest on excess reserves to bank~ has no cost to the 

taxpayer. 

To understand this statement, it is helpful to walk through the mechanics of how bank reserves 

are created. I will describe these mechanics in terms of a simple- and admittedly simplistic -

example, but the main message from this example applies much more generally. 
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Imagine we start with a situation in which I personally own a U.S. Treasury bond. Then the U.S. 

government regularly pays interest on this bond to me. Now suppose that I decide to sell this 

bond and that the Federal Reserve, as part of its monetary policy operations, purchases my 

bond. 1 When this transaction takes place, the Federal Reserve credits my bank (which is USAA) 

with reserves equal to the value of the bond, and USAA credits my bank account with the same 

amount. In this new situation, the Treasury pays interest on the bond to the Fed, the Fed pays 

interest on the reserves to USAA, and USAA pays interest on my bank account to me. 

In a broad sense, things have not changed much: the U.S. government is still paying interest on 

its debt and at least some of that interest is making its way to me. Instead of coming directly to 

me, however, the interest now passes through a chain of payments that includes the Fed and my 

bank. This point is important and bears repeating: The Federal Reserve paying interest on 

reserves is a link in a chain of payments that replaces interest payments the Treasury would 

otherwise be making directly to its bondholders.2 

The situation is not exactly the same as before, of course. (If it were, there would be no point to 

the Fed's asset purchase programs.) In particular, the interest rates are different in each step of 

this new chain. For concreteness, let me use some rough numbers. Ifi was holding a I 0-year 

bond, I was earning something like 1.75% from the Treasury. Now the Treasury pays that 1.75% 

in interest to the Fed, and the Fed pays 50 basis points to USAA. The difference between those 

two interest rates represents the Fed's earnings on the purchase of my bond. Since the Fed's 

earnings (net of expenses) are remitted back to the Treasury, this step represents a decrease in 

the Treasury's net financing costs. 

After the initial transaction, I may not want to keep my money in a bank account and may choose 

instead to buy some other type of security. When I do this, the reserves that were created when I 

sold my bond may be transferred from my bank to some other bank. In fact, they may be 

transferred many times as various transactions (including interbank borrowing and lending) 

occur. However, those same reserves will still exist somewhere in the banking system, and the 

key points I made above are unchanged. In particular, the Fed paying interest on those reserves 

wherever they are held is a link in a chain of payments that replaces interest payments the 

Treasury would otherwise be making to bondholders, and hence there is no cost to the 

government or to the taxpayer associated with those reserves. 

2) Removing the Fed's ability to pay interest on excess reserves would raise, not lower, the 

government's financing costs. 

There has been a fair amount of discussion about how the ability to pay interest on excess 

reserves is a critical policy tool for allowing the Federal Reserve to raise interest rates to the 

level that the FOMC deems appropriate. Without the ability to pay interest on reserves, the only 

1 In practice, the Federal Reserve does not buy securities directly from individuals. Instead, the Fed purchases 

securities from the primary dealers, and l would sell my bond to a primary dealer either directly or indirectly 

through another intermediary. These intermediate steps make the accounting more complex but in no way change 

the message of my simple example. 2 For an analysis of the fiscal implications of paying interest on reserves in a formal economic model, see Todd 

Keister, Antoine Martin, and James McAndrews "Floor Systems and the Friedman Rule: The Fiscal Arithmetic of 

Open Market Operations," Federal Reserve Bank of New York Staff Report No. 754, December 2015. 

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way the Fed could raise interest rates would be to quickly sell the majority of the securities in its 

portfolio and return its balance sheet to a much-smaller size. Chair Yellen and others have stated 

that they believe doing so could potentially destabilize markets and I largely agree with this 

assessment. 

I want to make a different point, however. Even if the Fed were to stop paying interest on excess 

reserves and dramatically shrink its portfolio of assets, doing so would not save the government 

or the taxpayer any money. This policy would eliminate the Fed's interest payments to banks. 

At the same time, however, it forces the Fed to sell a large quantity of government bonds from its 

portfolio. The interest payments made by the Treasury now go directly to the bond holders rather 

than to the Fed, and none of that interest is remitted to the Treasury. 

Thinking again about my simplistic example: suppose the Fed decides to sell the bond it 

purchased from me, and I decide to buy it back using the money that is still sitting in my bank 

account. These transactions extinguish the reserves that were created by the original purchase, 

so the Fed no longer pays any interest on these reserves to my bank. But to focus on the money 

saved at this one link in the chain is to miss the larger picture. The Treasury is now paying the 

1 .75% of interest to me rather than to the Fed. As a result, the net interest expense to the 

Treasury (and hence to the taxpayer) is now higher, not lower. 

3) Paying interest on excess reserves is not a subsidy to banks. 

Many people have expressed concern that the Fed's interest payments represent an unfair 

subsidy to banks. It is important to keep in mind, however, that while banks earn interest on their 

reserves, they also pay interest to their depositors. Returning again to my simple example, 

suppose I keep the money I received from the sale of the bond on deposit in my savings account. 

Then my bank would be earning 50 basis points on the newly-created reserves, but it would be 

paying me approximately 30 basis points on the new deposit. My deposit also increases the 

bank's costs indirectly, by raising the deposit insurance fees my bank must pay to the FDIC and 

by increasing my bank's leverage, which may require it to raise more capital. Taking all of these 

costs into account, my bank may make a small profit on the funds I have deposited with them, 

but to a first approximation they will roughly break even. 

This point becomes particularly important as we look to the future. As the economy continues to 

recover and interest rates rise further, the Fed will make even larger interest payments on the 

reserves held by banks. However, focusing exclusively on the size of the interest payments the 

Fed makes to banks again misses the broader picture. While banks will be earning a higher 

interest rate on their reserve holdings, they will also be paying a higher interest rate to their 

depositors and other creditors. In addition, the Fed's payment of a higher interest rate on reserves 

is replacing t~e higher interest payments the Treasury would otherwise be making directly to 

bondholders.> 

3 Asset purchases by the Fed do influence the size ofthe Treasury's net financing costs by changing the maturity 

structure of the public sector's combined liabilities (that is, Treasury securities plus reserves). But higher interest 

rates will raise the Treasury's cost of financing the U.S. government debt regardless of whether interest is paid 

directly by the Treasury to bondholders or indirectly to savers through the chain involving the Fed and interest on 

reserves. 

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4) This is true even when market interest rates are lower than the interest rate on excess 

reserves. 

The interest rate paid on excess reserves establishes the benchmark interest rate for the entire 

economy: it is the rate associated with a safe, perfectly liquid asset that can be used by a bank to 

make payments and settle financial transactions at a moment's notice. All other interest rates in 

money markets effectively are priced off of this rate. 4 

Prior to 2008, when the interest rate on excess reserves in the U.S. was zero, the Fed needed to 

create a scarcity of reserves to keep market interest rates positive. The Fed did this by supplying 

just enough reserves for banks to meet their minimum reserve requirements. Because reserves 

were scarce and individual banks constantly faced the possibility of falling below their reserve 

requirement, banks were willing to pay a positive interest rate to borrow reserves from one 

another. By controlling precisely how scarce reserves were, the Fed could effectively control the 

interest rate in this federal funds market. 

Currently, the Fed has created what I will call a "super-abundance" of reserves. The quantity of 

reserves is large enough that banks are no longer willing to pay a premium to borrow reserves 

from one another or from other participants in money markets. 5 In fact, because of costs 

associated with increased deposit insurance fees and increased leverage, banks arc currently 

willing to pay less than 50 basis points to borrow reserves. 

This super-abundance of reserves helps explain why many money market interest rates currently 

lie below the interest rate paid on excess reserves. Whereas in the pre-crisis environment banks 

were willing to pay to hold reserves because these reserves were scarce, in the current 

environment banks must be compensated because holding reserves is costly at the margin. Once 

the FOMC decides to start shrinking the Fed's balance sheet and the level of reserve balances 

declines, I expect the gap between the interest rate on excess reserves and money market interest 

rates to narrow and eventually disappear as these costs of holding reserves decline. 

I believe this logic also helps explain why the FOMC has decided to set the interest rate at its 

overnight reverse repurchase agreement (ONRRP) facility lower than the interest rate on excess 

reserves. Participants in the ONRRP facility are largely non-bank financial institutions, 

including money market mutual funds. These institutions do not pay deposit insurance 

premiums and do not face the same balance sheet costs as banks. If the Fed were to set the 

interest rate at the ONRRP facility equal to the interest rate on excess reserves, it would likely 

encourage a large flow of deposits out of banks and into money market mutual funds and other 

non-bank institutions that have access to the ONRRP facility. 

4 This fact implies that it would be undesirable for the Fed to announce that it will pay the "market interest rate" on 

excess reserves. Market interest rates are set in reference to the Fed's policy rate. If the Fed tried to set that policy 

rate equal to a market rate, it would create a circular or self-referencing process that could easily prove unstable. 

This type of problem has long been recognized in the economics literature; see, for example, Thomas Sargent and 

Neil Wallace, "Interest on Reserves," Journal of Monetary Economics Vol. 15, No.3, May 1985. 5 The primary lenders in the federal funds market in recent years have been non.depository institutions that are not 

eligible to earn interest from the Fed, including government-sponsored enterprises (GSEs). See Gara Afonso, Alex 

Entz, and Eric LeSueur, "Who's Lending in the Fed Funds Market?" Liberty Street Economics, December 2, 2013. 

4 
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In principle, this flow is not necessarily bad. It may, for example, lead to savers earning a 

slightly higher interest rate. However, there are also risks associated with encouraging a large 

flow of funds out of the regulated banking system. Such a development could, for example, leave 

the financial system more susceptible to future panic-like events. In addition, this plan would 

result in much higher usage of the Fed's ONRRP facility. Given that this facility is still 

relatively new and is operationally more complex than paying interest on bank reserves, the Fed 

might prefer to keep the size of the facility more modest. 

For these reasons, my reading is that the Fed has chosen to set the interest rate at the ONRRP 

facility in a way that creates a "level playing field" for banks and non-bank financial institutions 

(including money market mutual funds) in competing for deposits. That is, the gap between the 

two interest rates is calibrated to roughly reflect the extra costs that banks face in taking 

additional deposits and holding reserves. The data on the usage of the ONRRP facility is 

consistent with the playing field being roughly level. If the gap between the two rates were small 

enough to give money market funds a clear advantage over banks in attracting deposits, we 

should see large flows of deposits out of banks and heavy usage of the ONRRP facility. If the 

gap were wide enough to give banks a decisive advantage in attracting deposits, we should see 

no usage of the facility. So far, there has been a positive-but-modest usage of the facility, which 

is consistent with the playing field being level. 

5) Reserves do not represent money that that banking system is "not lending out." 

There is a tendency at times to view the large quantity of reserves held by banks as an indication 

that these banks are not lending as much to businesses and consumers as they otherwise could. 

This view, however, is based on a fallacy of composition. While an individual bank can choose 

to lend out its reserves, the same is not true of the banking system as a whole. The total quantity 

of reserves in the banking system is determined almost entirely by the Fed's actions- how many 

securities it holds in its portfolio. 6 Actions taken by individual banks change the distribution of 

reserves across banks, but do not change the total quantity of reserves in the banking system. 

Moreover, as illustrated in my simple example above, when the Fed creates reserves by 

purchasing securities from the public, this action also automatically creates bank deposits for the 

individuals or institutions selling the securities. As a result, both the assets and the liabilities of 

the banking system increase. The reserves that banks hold are not displacing other assets on their 

balance sheets, like loans to businesses or consumers; these reserves are, in general, held in 

addition to banks' other assets. In other words, the Fed's creation of a large supply of reserves 

does not restrict banks' ability or incentive to lend funds to businesses and consumers. 

6) Policy makers should encourage banh to hold excess reserves, not discourage them. 

Bank reserves are the lifeblood of our nation's payments system. Every business day, more than 

$3 trillion of payments are made over the Fed wire Funds Service, the large-value wholesale 

6 There are exceptions to this point, such as when a bank requests to withdraw currency from the Fed and thereby 

decreases the total quantity of reserves, but these so-called "autonomous factors" are relatively small. For a detailed 

discussion of this issue, see Todd Keister and James J. McAndrews "Why Are Banks Holding So Many Excess 

Reserves," Current Issues in Economics and Finance Vol. 15, No. 8~ Dec. 2009. 

5 
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payments system operated by the Federal Reserve. These payments represent a wide variety of 

activity in the economy, including large financial transactions but also down payments on home 

purchases, mortgage payments, business' payments to suppliers, etc. Banks make these payments 

on behalf of their customers using the reserves they hold on deposit at the Fed. Given the 

enormous volume of payments that need to be made, the potential arises for bottlenecks, delays, 

and increased risks in the payments system when there are insufficient reserves avai !able. 

When the Fed did not pay interest on reserves, implementing monetary policy required the Fed to 

supply a relatively small quantity of reserves. In this setting, reserves were sufficiently scarce 

that our payments system could not adequately function using those reserves alone. Instead, the 

Federal Reserve provided intraday credit to banks, permitting banks to run overdrafts in their 

reserve accounts for a few hours each day solely for the purpose of allowing the payment system 

to function effectively. These overdrafts were at times large, with an average daily peak of more 

than $180 billion in 2007. 

One byproduct of the large expansion of bank reserves that has occurred over the past few years 

has been a dramatic decrease in these daylight overdrafts together with a smoother functioning of 

the payments system. Peak intraday overdrafts have fallen by more than 90%- to less than $10 

billion- and research shows that payments are, on average, being sent significantly earlier in the 

day, reducing delays and enhancing the resilience of the payments system. 7 

Paying interest on excess reserves allows the Federal Reserve to raise interest rates without 

creating a scarcity of bank reserves. The ability to pay this interest is thus not only critical for the 

conduct of monetary policy, it also enables the Fed to simultaneously vromote safety and 

efficiency in the payment network that underlies our financial system. 

7) The Fed's balance sheet should remain larger than its pre-crisis level. 

The Fed's pre-crisis framework for implementing monetary policy required creating a scarcity of 

bank reserves and precisely controlling the level of this scarcity to achieve the desired interest 

rate. As the economy continues to recover, the FOMC has stated that the size of the Fed's 

balance sheet will shrink substantially from its current level. It would be a mistake, however, for 

the Fed to try to return the balance sheet to its pre-crisis size or to the pre-crisis composition of 

its liabilities. 

There have been substantial changes in the financial system since 2008, including the new 

regulations that aim to promote the stability of the banking sector. These regulations, including 

the new Liquidity Coverage Ratio, are increasing banks' demand for safe, liquid assets, including 

excess reserves. A framework for implementing monetary policy that relies on a scarcity of bank 

reserves not only runs counter to the goals of the new regulations, but will also likely have more 

difficulty achieving the desired level of market interest rates than in the past. 9 

7 See Morten L. Bech, Antoine Martin, and James McAndrews, "Settlement Liquidity and Monetary Policy 

Implementation-Lessons from the Financial Crisis," FRBNY F,conomic Policy Review, Vol. 18, No. I, March 2012. 

'For further discussion of this issue, see Todd Keister, Antoine Martin, and James McAndrews, "Divorcing Money 

from Monetary Policy," FRBNY Economic Policy Review, Vol. 14, No.2, September 2008. 9 For a detailed analysis of this issue, see Morten Bech and Todd Keister, "Liquidity Regulation and the 

Implementation of Monetary Policy," Bank for International Settlements Working Paper 432, October 2013. 

6 
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A more effective approach to implementing monetary policy in the future would be for the Fed 

to rely primarily on the interest rate on excess reserves to steer market rates while maintaining a 

balance sheet large enough to eliminate the scarcity value of reserves. 10 This size would be 

substantially smaller than the Fed's current balance sheet; a super-abundance of reserves is not 

necessary for this purpose. But guiding the level of excess reserves down to, say, $100-$200 

billion, while continuing to pay interest on those excess reserves, would be a more reliable and 

efficient way of implementing monetary policy than trying to reinstate the Fed's pre-crisis 

operating regime. 

8) While paying interest on required reserves does result in a net cost to the Treasury, it is 

nevertheless sound economic policy. 

When Congress first authorized the Federal Reserve to pay interest on reserves in 2006, there 

was extensive discussion of the fiscal implications of paying interest on required reserves, that 

is, reserve balances held by banks to meet their statutory reserve requirement. The interest rate 

paid on required reserves does not directly influence money market interest rates because each 

bank must hold these reserves regardless of the cost. For this reason, the policy discussion at that 

time was focused not on implementing monetary policy, but rather on removing distortions in the 

banking sector. 

When no interest was paid on required reserves, reserve requirements effectively acted as a tax 

on the activity of banking. To mitigate the impact of this tax, banks had an incentive to minimize 

their deposits that are subject to the reserve requirement. They did this by, for example, using 

sweep arrangements to move funds from deposits that are subject to these requirements to ones 

that are not. As testified by Governor Donald Kohn at the time, these arrangements "absorb real 

resources and therefore diminish the efficiency of our banking institutions." 11 They also 

decreased the level of reserves in the banking system needed for monetary policy purposes, 

exacerbating the shortage of reserves in the payments system. 

By paying interest on required reserves, the Fed removes the reserve tax and eliminates the 

incentive for banks to engage in these reserve avoidance activities. The resulting increase in 

efficiency encourages the banks to extend more credit to businesses and consumers and thereby 

improves economic performance. In contrast with excess reserves, however, paying interest on 

banks' required reserves does reduce the Federal Reserve's remittances to the Treasury. As with 

any tax reduction, there is a cost to the government in lost revenue. However, this reduction in 

revenue is proportional to banks' holdings of required reserve balances, which are relatively 

small. In passing the Financial Services Regulatory Relief Act of2006, Congress decided that 

eliminating this tax on banking activity was desirable. In my view, that decision continues to be 

appropriate. 

10 This approach has been advocated, for example, in Marvin Goodfriend, "Interest on Reserves and Monetary 

Policy," FRBNY Economic Policy Review Vol. 8, No. 1, May 2002. 11 Testimony of Governor Donald L. Kobn before the Commil!ee on Banking, Housing, and Urban Affairs, U.S. 

Senate, June 22, 2004. 

7 
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Conclusion: 

The ability to pay interest on reserves is a valuable policy tool for the Federal Reserve. 

Understanding the importance of this tool for monetary policy, as well as the fiscal implications 

of using it, requires looking at these interest payments in a broad context. As I have outlined 

above, it is particularly important to realize that when the Federal Reserve creates excess 

reserves and pays interest on those reserves, this action creates no cost to the government or to 

the taxpayer. Instead, the interest on reserves paid to banks is a part of a chain of payments that 

replace interest payments the U.S. Treasury would otherwise be making directly to its 

bondholders. Moreover, by allowing the Fed to implement monetary policy more efficiently and 

with a larger supply of reserves, paying interest on excess reserves helps promote a safer and 

more resilient payments system. 

Thank you again for this opportunity to testify before you today. I would be happy to answer 

any questions. 

8 
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Proposed Testimony 

Before the U.S. House of Representatives Committee on Financial Services 

Monetary Policy and Trade Subcommittee 

Hearing on "Interest on Reserves and the Fed's Balance Sheet" 

Washington, D.C. 

George Selgin 

Director, Center for Monetary and Financial Alternatives, Cato Institute 

May 17,2016 

Chairman Huizenga, Ranking Member Gwen Moore, and distinguished members of the 

Committee on Financial Services Monetary Policy and Trade Subcommittee, my name is George 

Selgin, and I am the Director of the Cato Institute's Center for Monetary and Financial 

Alternatives. I am also an adjunct professor of economics at George Mason University, and 

Professor Emeritus of Economics at the University of Georgia. I am grateful to all of you for 

having granted me this opportunity to testify before you on the subject of "Interest on Reserves 

and the Fed's Balance Sheet." 

The Federal Reserve was originally given the authority to pay interest on bank reserves 

effective October I, 2011 by the Financial Services Regulatory Relief Act of2006. The intent of 

that step was to increase commercial banks' efficiency by reducing the opportunity cost they 

incurred in being required to hold reserves that bore no interest. 

The Emergency Economic Stabilization Act of 2008 subsequently accelerated the 

effective date upon which the Fed might begin paying interest on reserves to October 1, 

2008. The Fed in turn actually began paying banks interest on both required reserves and excess 

reserves on October 9, 2008. 

The rationale behind the early deployment of the Fed's authority to pay interest on 

reserves was entirely different from that behind the original, 2006 measure. Interest on reserves 

(henceforth IOR) was to be relied upon, not as a means for improving banks' efficiency, but as a 

new Federal Reserve instrument of monetary control. Specifically, it was resorted to as a 

contractionary monetary measure, meant to prevent monetary expansion that would otherwise 
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have taken place as a consequence of the Fed's post-Lehman emergency lending operations. As 

Chairman Ben Bemanke explained at the time: 

our liquidity provision had begun to run ahead of our ability to absorb excess reserves 

held by the banking system, leading the effective funds rate, on many days, to fall below 

the target set by the Federal Open Market Committee .... Paying interest on reserves 

should allow us to better control the federal funds rate, as banks are unlikely to lend 

overnight balances at a rate lower than they can receive from the Fed; thus, the payment 

of interest on reserves should set a floor for the funds rate over the day. With this step. 

our lending facilities may be more easily expanded as necessary. 1 

In his memoir Chairman Bemanke says that "by setting the interest rate we paid on reserves high 

enough, we could prevent the federal funds rate from falling too low, no matter how much 

[emergency]lending we did.2 

According to Richmond Fed economists John R. Walter and Renee Courtois, Fed 

officials were concerned at the time that, in pushing the fed funds rate below its target, the Fed's 

emergency credit injections might end up "increasing the overall supply of credit to the economy 

beyond a level consistent with the Fed's macroeconomic policy goals, particularly concerning 

price stability .... Once banks began earning interest on the excess reserves they held, they would 

be more willing to hold on to excess reserves instead of attempting to purge them from their 

balance sheets via loans made in the fed funds market, which would drive the fed funds rate 

below the Fed's target for that rate."3 

The Fed's decision had reflected the FOMC's belief in the days immediately following 

Lehman's failure that the inflation outlook was highly uncertain, and that, in the absence of 

interest payments on reserves, continued emergency lending could well push inflation above the 

Fed's 2% target. In retrospect, the Fed's fears were tragically misplaced. Instead of assisting it in 

achieving either its federal funds rate or its inflation target, the Fed's decision to begin paying 

interest on bank reserves contributed to a collapse in nominal spending that was already in 

progress, helping thereby to tum the subprime crisis into a more general macroeconomic 

downturn. That the Fed realized that the macroeconomic situation was rapidly worsening even 

1 (http://www. federalreserve. go v /newsevents/speech/bernanke20081 007 a.htm) 2 (Courage to Act, pp. 325-6). 3

https://www.richmondfed.org/-/media/richmondfedorg!publications/research/economic brief/2009/pdf/e 

b 09-l2.pdf 

2 
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before it actually began paying interest on reserves was reflected in its decision to further reduce 

its federal funds target, from 2% to 1.5%, on October 8, 2008. The Fed chose not to reconsider 

its decision to commence paying banks to hold reserves a day later. 

The rapid decline in the growth rate of nominal GDP, from about 3.5% at the start of 

2007 to minus 3.3% by the second quarter of 2009, is shown in Figure I, which also shows the 

progress of adjustments to the fed funds target and the "effective" federal funds rate, which is the 

average rate of interest paid on actual overnight loans. The collapse in spending is ipso-facto 

evidence that the Fed's stand was overly tight. The figure shows that the Fed's rate target had 

become more-or-less irrelevant by the third quarter of2008, and that this continued to be the 

case after it began paying interest on bank reserves. The latter policy did, however, reduce the 

volume of interbank lending and overall credit expansion, contributing thereby to the collapse of 

nominal GDP. 

Figure 1 

The Fed's policy of paying interest on excess reserves, combined with the substantial 

scale of its post-Lehman emergency lending and the even greater scale of later rounds of 

Quantitative Easing, led to a massive accumulation of banking system excess reserves. As Figure 

3 
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2 shows, excess reserves, which between 2002 and 2008 had seldom exceeded $1.8 billion, had 

risen to almost $2.7 trillion in August 2014, and as of this April still exceeded $2.33 trillion. 

Figure 2 

Although some authorities4 have claimed that the scale of the Fed's reserve creation 

alone made a corresponding increase in bank holdings of excess reserves inevitable, that is not 

correct. Although the total quantity of bank reserves is largely determined by the Fed's rather 

than commercial bankers' decisions, banks are always capable in principle of reducing their 

holdings of excess reserves by swapping them for other assets. Although the swapping does not 

destroy reserves, it does result in overall growth in the quantity of bank deposits, together with a 

corresponding increase in required reserves and a like reduction in excess reserves. Until the 

third quarter of2008 this process kept bank excess reserves roughly constant despite steady 

growth in total Federal Reserve Bank assets and the monetary base; and it might have done the 

4 See, for example, Todd Keister and Gaetano Antinolfi, 

http://libertystreeteconom ics. newyorkfed.org/20 12/08/interest -on-excess-reserves-and-cash-parked -atthe-fed.html#. Vzog60RGR2A 

4 
71 


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same afterwords had circumstances not been such as to encourage banks to accumulate excess 

reserves. Nor did the tremendous scale of the Fed's asset purchases itself matter: dDuring the 

notorious Weimar hyperinflation, for example, the growth in total bank reserves far exceeded 

that witnessed in the U.S. since Lehman's bankruptcy. Yet Germany's banks, instead of 

accumulating excess reserve, increased their lending and deposit creation proportionately, and 

eventually more than proportionately, with terrible consequences. 

Nor is U.S. banks' decision to accumulate excess reserves attributable to the panic that 

followed the Fed's decision to allow Lehman Brothers to go bankrupt. 5 Although banks' fear 

that their counterparties might be allowed to go bankrupt would make them reluctant to lend to 

other banks, it alone would not necessarilty cause them to decisively favor reserves over low-risk 

Treasury securities. Furthermore, as Figure 3 shows, although the TED spread-a widely-used 

measure of the perceived risk of bank failures, equal the difference between the interest rate on 

short-term interbank lending and the interest rate on Treasury securities-spiked not long after 

Lehman's failure, the spread returned to norma! levels afterwards, mainly in response to the 

Fed's decision to rescue AIG, while banks' excess reserve holdings did not. The persistent 

increase in bank holdings of excess reserves suggest that the payment of interest on such 

reserves, rather than banks' reassessment of the risk of counterparty failures, is behind the 

increase. 

5 This claim has been put forward Alex Cukierman, among others. See "U.S. Banks' Behavior since 

Lehman's Collapse, Bailout Uncertainly and the Timing of Exit Strategies." Working paper, August 30, 

2014. 

5 
72 


24067.031

Figure 3 

Finally, the timing of the substantial rise in banks' excess reserve holdings, as shown in 

the next chart, is also consistent with the view that the Fed's policy of paying interest on excess 

reserves contributed more to the increase than Lehman's failure did. As Figure 4 shows, although 

banks accumulated excess reserves immediately following Lehman's failure, most of the 

increase in excess reserves occurred after the Fed began paying interest on reserves. 

6 
73 


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Figure4 

Some experts doubt that the very modest return on excess reserves-for most of the 

period between October 2008 and December 20 15 the rate of interest on excess reserves was 

fixed at just 25 basis points--can have sufficed to induce banks to hoard reserves. However, 

banks' willingness to hold excess reserves depends, not on the absolute return on such reserves, 

but on how that return compares to the return on alternative liquid and risk-free assets, such as 

Treasury bills. As Figure 5 shows, the interest rate on excess reserves has generally exceeded the 

yield on Treasury bills. The same figure shows how the volume of interbank loans has tended to 

vary according to the difference between the rate of interest on excess reserves and the yield on 

Treasury securities, which can be regarded here as a proxy for market rates more generally. 

7 
74 


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Figure 5 

Because reserves began to bear a higher return than safe governments securities, the 

demand for those securities did not increase substantially after Lehman's failure (Figure 6). 

Figure& 

8 
75 


24067.034

As I've noted, a desire to prevent its emergency lending from contributing to the 

availability of federal funds supplied the original inspiration for the Fed's decision to begin 

paying interest on bank reserves, so it is no surprise that the policy should have been responsible 

for the actual decline in interbank lending that took place after Lehman's failure. Once they were 

able to earn interest on their excess reserves exceeding the effective federal funds rate, banks 

(mainly smaller ones) that until the crisis had generally been net interbank lenders, withdrew 

from that market, while those (mainly larger ones) that had previously tended to participate as 

borrowers found it both necessary and no longer onerous to hold substantial quantities of excess 

reserves instead. 

Besides contributing to the collapse in interbank lending, the Fed's decision to reward 

banks for holding excess reserves prevented the creation of additional reserves from giving rise 

to corresponding growth in other kinds of bank credit by short -circuiting of the base-money 

"multiplier" that normally connects growth in bank reserves to more substantial growth in bank 

deposits. As the Figure 7 shows, the Ml multiplier, the ratio ofMI (currency in circulation plus 

demand deposits) to the monetary base (currency in circulation plus total bank reserves) fell from 

1.617 on September lOth to half that value by the beginning of2010. 

Figure 7 

9 
76 


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The collapse of the money multiplier was in turn responsible for the failure of the Fed's 

large-scale asset purchases to give rise to any corresponding increase in bank deposits, bank 

credit, and nominal GDP. Instead, banks' holdings of excess reserves grew almost in lock-step 

with the Fed's creation of new base money. Had banks not been rewarded for holding excess 

reserves, a much smaller program of Quantitative Easing might have given rise to a much more 

substantial increase in bank deposits, bank lending, and nominal GDP. 

Partly owing to the repressive effect of interest on reserves on bank deposit creation, 

most forms of bank lending, instead of being revived by the Fed's creation of fresh bank 

reserves, remained stagnant or (in the case of Commercial and Industrial Loans) continued to 

decline long after Lehman's failure. Commercial and Financial Lending declined until the third 

quarter of 20 I 0, as seen in Figure 8. And although it has made up for lost ground since, it 

remains well below the level consistent with its pre-boom trend. Moreover, because the crisis 

resulted in a large and lasting decline in net "shadow" bank lending to non-financial firms,6 

especially by Money Market Mutual Funds, much of the revival in commercial bank lending has 

consisted of lending to corporate borrowers that had previously relied upon funding from shadow 

banks. Lending to small businesses has suffered correspondingly. 

6 See Joshua Gallin, "Shadow Banking and the Funding of the Nonfinancial Sector." Working paper 

2013:50, Federal Reserve Board. 

10 
77 


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Figure 8 

Banks' unprecedented accumulation of excess reserves has as its counterpart a very large 

Fed balance sheet relative to both overall economic activity and private lending. As Figure 9 

shows, the increase relative to GDP is the largest since the World War II era, when the Fed was 

committed to setting a floor on the governments' wartime borrowing costs by serving as a "last 

resort" purchaser of its bonds. 7 That commitment finally ended with the so-called "Treasury 

Accord" of 1951.8 Although the Fed's balance sheet reached its highest historical level relative 

to GDP during the Great Depression, that record mainly reflected that era's extreme drop in 

GDP, as opposed to growth in the absolute size of the Fed's balance sheet. 

7 The chart comes from Lowell R. Ricketts and Christopher J. Waller, "The Rise and (Eventual) Fall in 

the Fed's Balance Sheet." The Regional Economist, January 2014, Federal Reserve Bank of St. Louis. 8 A still larger ratio during the Great Depression mainly reflected the tremendous GDP collapse of that 

episode rather than of absolute growth in the Fed's size. 

11 
78 


24067.037

Figure9 

Historical View of Federal ReseJVe Balance Sheet 

25 • 

Substantial growth in the Fed's balance sheet, combined with the incomplete revival of 

bank lending since the crisis, has caused the Fed's overall share of money-based financial 

intermediation to triple, as seen in Figure I 0: 

Figure 10 

12 
79 


24067.038

Such a large increase in the Fed's role in the allocation of scarce savings is much to be 

regretted, as it almost certainly means that those savings are not being devoted to their most 

productive or welfare-enhancing uses. At best central banks are inefficient financial 

intermediaries, not the least because efficient intermediation forms no part of their official 

responsibilities. Instead, their acquisition of interest-earning assets is supposed to be incidental to 

their tasks of regulating overall monetary conditions and serving as lenders of last resort. They 

are, furthermore, generally supposed to avoid exposing themselves-and, indirectly, taxpayersto loss, and are for that reason expected to fully secure their last-resort loans and to limit their 

outright asset purchases to safe government securities. Commercial banks, in contrast, are not 

similarly constrained, and cannot be if they are to take full advantage of opportunities for 

productive lending. 

Until the recent crisis, the Fed was no exception to the general rules governing central 

banks. Before early 2008 Fed assets consisted overwhelmingly of U.S. Treasury bills, notes, and 

bonds. Since the crisis, however, the Fed's asset holdings have changed considerably, in ways 

that generally involve still greater departures from any efficient use of scarce funds, including a 

substantial increase in MBS holdings and long-term Treasury securities acquired during several 

rounds of Quantitative Easing (Figure 11): 

Figure 11 

Federal Reserve Asset Composition (% of GOP} 

30% 

25% 

;.: F~era!~ru:.y Otbt Sconitiii.!S 

s Mt»1'~·b;M;k~ SIM;~ir~tk'!.> 

lll Other OPt'-riH.i<N» 

Nl f'X~W..}p$ 

W: ~f("h<&s.il' o1 fiOI"Hi(:t)Vt.'~"Tlrtl~l,t ~ritte$ 

20% 

2; 

~15% 

.. "

5% 

0% 

2007 

Market Realist e. 

200ll 2009 2010 2011 2012 2013 

13 

2014 
80 


24067.039

Although the Fed's crisis-related asset purchases may have been instrumental in 

combating the panic and subsequent recession, its continued holding of non-traditional assets 

long afterwards constitutes a serious distortion in the allocation of scarce capital, including a 

perpetuation of the very misallocations of which irresponsible private lenders (encouraged in 

many cases by government policies9

) were guilty in the years leading to the crisis. 

Despite the counterproductive consequences of the Fed's original decision to employ 

interest payments on bank reserves as an instrument of monetary control, and the inefficient 

allocation of savings to which banks' hoarding of excess reserves contributes, the Fed continues, 

seven and a half years since tbe crisis, not only to rely on that new instrument, but to rely on it 

and changes in the interest rate it offers in its overnight reverse repurchase agreements (ON 

RRPs) exclusively for monetary control purposes, while dispensing entirely with traditional open 

market operations. Its decision to do so, and more specifically, to maintain a positive rate of 

interest on excess reserves, and even to increase that rate (as it did in mid-December 2015), is to 

be regretted. 

The December rate hike itself appears in retrospect to replicate the Fed's error of October 

2008, when it employed interest on reserves to avoid an unwanted loosening of credit, on the 

grounds that such a loosening might prevent it from achieving its policy targets. In electing last 

December to raise the interest rate paid on excess reserves from 25 to 50 basis points, the FOMC 

pointed to a "considerable improvement in labor market conditions," while declaring that it was 

"reasonably confident that inflation will rise, over the medium term, to its 2 percent objective."10 

As of this writing, both core and headline PCE inflation remain below the Fed's 2% target, while 

the unemployment rate is again at 5%, its level in October 2015. Many observers have since 

concluded that the December rate hike was a mistake. 

However, it would be more accurate to claim that, while the December doubling of the 

rate of interest paid on excess reserves was a mistake, the decision to pay 25 basis points on 

those reserves was a mistake as well. As David Beckworth has put it in a blogpost on the topic, 

9 See Peter Wallison, Hidden in Plain Sight: What Really Caused the World's Worst Financial Crisis and 

i¥hy It Could Happen Again. New York: Encounter Books, 2015. 10 https://www.federalreserve.gov/newsevents/press/monetar:y/20 151216a.htm 

14 
81 


24067.040

"The Fed ... got ahead of the recovery well before December." 11 According to the Fed's own 

estimates, as seen in Figure 12 below, the "natural" fed funds rate, which is the rate consistent 

with a stable level of spending growth and inflation, has been persistently negative since Lehman 

went bankrupt. Consequently, in setting a positive funds rate target band, the upper bound of 

which was determined by the interest rate on excess reserves, the Fed maintained an excessively 

tight policy. 

Figure 12 

20 

15 

10 

-5 

-10 

'"'"""""''"'""'"""' ............. ..___. ·15 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 

Note: The shaded bars Indicate periOds of business recession as defined by t:tte National Bureau of Economic Research. 

Source: The estimates are drawn from four models: (1} a dynamic stochastic general equllibrium (OSGE) model developed by the staff of 

the Federal Reserve Board and described In Kiley (2013); (2) a DSGE tncdel deveJoped by the staff of the Federat Reserve Bank of New York 

and described ln Del Negro and others (2013); (3) a OSGE model developed by the staff of the Federal Reserve Board based oo Christiano. 

Motto, and Rostagno (2014); and {4) a DSGE model developed by the staff of the Federal Reserve Board based on Guerrieri and 

Iacoviello {2013 [rev. 2014}). 

It is owing to the perception that natural rates in their own struggling economies are also 

negative that several foreign central banks, including the ECB and the central banks of Denmark, 

Sweden, Switzerland, and, starting in January this year, Japan, have turned to charging rather 

than paying interest on bank excess reserve holdings. The step has been controversial, and its 

consequences have not clearly fulfilled the hopes oftbose central bankers that have resorted to it. 

However, regardless of its merits the policy tum raises obvious questions concerning the Fed's 

decision to continue pursuing its opposite strategy. 

Besides contributing to what may have been an excessively tight policy stance, the 

continuation of interest payments on excess reserves also serves to perpetuate the Fed's 

unusually heavy involvement in the allocation of savings, and the consequent mal-investment of 

those savings. 

11 http://macromarketmusings.blogspot.com/20 16/02/the-fed-did-not-make-mistake-in-december.html 

15 
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24067.041

The alternative to continuing the present policy is, of course, to dispense with interest 

payments on excess reserves while restoring conventional open market operations as the Fed's 

primary instrument of monetary control. Restoring efficient credit allocation in turn means 

reducing the size of the Federal Reserve's balance sheet both absolutely and relative to that of 

private intermediaries. 

For the Fed to do all of these things while maintaining a proper monetary policy will be 

challenging. But for it to avoid taking these steps is for it to continue to contribute to the 

economic malaise that has made for a slow and still unsatisfactory recovery from the 2008 crisis. 

And although the task of normalizing monetary policy may be difficult, it is hardly impossible. 

The phasing-out of interest on excess reserves, together with the lowering of interest payments 

on ON RPPs, will help to revive the money multiplier, thereby not just allowing but necessitating 

a compensating unwinding of the Fed's post-crisis balance sheet. If it isn't to disrupt markets the 

unwinding must be both gradual and anticipated: one proposal would have the Fed begin by 

committing to sell $4-$5 billion in short-term Treasuries each week. 12 Such a sale would, 

incidentally, more than make up for the reduction in Fed interest payments to Money Market 

Funds, by returning to the marketplace securities that such funds have long been craving. 

Having the Fed return to its pre-crisis policy of zero interest on excess reserves does not 

mean forgetting the arguments that supported the 2006 legislation that originally granted the Fed 

the right to pay interest on reserves. However, meeting the spirit of those arguments requires 

only that the Fed be able to pay interest on banks' required, as opposed to their excess, reserves. 

So long as excess reserves bear no interest, banks have little reason to accumulate them, and 

would therefore suffer little from the inefficiency connected to their slight holdings. Economic 

efficiency is in any case better enhanced by encouraging banks put excess reserves to use, than 

by paying them to hoard such reserves. 

12 http://www.ft.com/cms/s/0/520377e8-()37e-ll e5-b55e,pj)J 44feabdcO.html#axzz48g3Y ArDG. See also 

Norbert Michel (http://www.heritage.org/research/reports/20 14/08/quantitative-easing-the-feds-balancesheet-and-central-bank-insolvency), who proposes that the Fed take until2020 to sell75% of its longterm securities and MBS, at a rate of $45 billion each month, while holding the other 25% until they 

mature. 

16 
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24067.042

Interest on Reserves and the Fed's Balance Sheet 

John B. Taylor1 

Testimony before the Subcommittee on Monetary Policy and Trade 

Committee on Financial Services 

U.S. House of Representatives 

May 17,2016 

Chair Huizenga, Ranking Member Moore, and members of the Subcommittee on 

Monetary Policy and Trade, thank you for inviting me to testify at this hearing on "Interest on 

Reserves and the Fed's Balance Sheet." Because reserves are a very large part of the Fed's 

balance sheet, I will start with the balance sheet. I then consider the issue of the Fed paying 

interest on these reserves. 

Changes in the Fed's Balance Sheet 

The best way to understand what has happened to the Fed's balance sheet in recent years 

is to look at the actual balance sheet-the consolidated statement of assets and liabilities of all 

Federal Reserve Banks. The table below gives two snap shots of the Fed's balance sheet, one 

taken in 2016 and the other in 2006. 

Fed's Balance Sheet (Billions of dollars) 

Assets 

Securities Held Outright 

Other 

Tot a I Assets 

Assets 

Securities Held Outright 

Other 

Total Assets 

4,234 

244 

4,478 

760 

82 

842 

Mayll, 2016 

Liabilities 

Federal Reserve Notes 

Reserve Balances 

other 

Total Liabilities 

MaylO, 2006 

Liabilities 

Federal Reserve Notes 

Reserve Balances 

Other 

Total Liabilities 

1,407 

2,410 

621 

4,438 

758 

14 

41 

813 

Source: Federal Reserve Statistical Release H.4.1, May 12, 2016, May 11, 2006, Selected Items 

1 Mary and Robert Raymond Professor of Economics at Stanford University, George P. Shultz 

Senior Fellow in Economics at Stanford's Hoover Institution, and former Under Secretary of 

Treasury for International Affairs, 2001-2005 

1 
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24067.043

The table focusses on the Fed's major assets and liabilities, lumping everything else into 

"other liabilities" and "other assets" categories. The two points in time--the week ending May 

II, 2016 and the corresponding week ending May 10, 2006--give before and after pictures of 

the major changes in size and composition of the Fed's balance sheet. 

First note how the "size" of the balance sheet-measured by total assets-has expanded 

enormously over these years-from $842 billion to $4,4 78 billion. The table shows the two 

major reasons for the increase. First, currency (Federal Reserve notes) increased from $758 

billion to $1,407 billion, or about a 6% average annual growth rate. There is nothing very 

unusual about this increase in currency; the annual growth rate was in this range in prior decades. 

The second reason is much more unusual: Securities held outright by the Fed jumped 

from $760 billion to $4,234 billion as the Fed engaged in three bouts of large-scale purchases of 

Treasury securities and mortgage-backed securities-actions commonly called "unconventional" 

monetary policy or "quantitative easing".2 

To get the funds to purchase these securities, which increased by much more than the 

increase in currency, the Fed credited banks with deposits on itself, and for this reason reserve 

balances-the deposits that banks hold at the Fed-have exploded from only $14 billion to 

$2,41 0 billion as shown in the table. This large increase in reserve balances is very important 

because it is on these reserve balances that the Fed is paying interest today. 

The following chart of reserve balances each week over this period provides some 

important details about the increase and shows how unusual it has been. 

Billions of dollars 3,000 QE3 

2,500 

Reserve Balances 

2,000 at the Fed 

1.500 

1,000 

500 

9/11 

0 Year 00 02 04 06 08 10 12 14 

2 Another term is "credit easing" because the securities purchases or loans are in part aimed at 

easing credit conditions in certain sectors, such as housing. I have also used the term 

"mondustrial policy" because such sector- specific policies are a combination of monetary policy 

and industrial policy. (See John B. Taylor "The Need to Return to a Monetary Framework," 

Business Economics, Vol44, No 2, 2009, pp. 63-72. 

2 
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24067.044

Reserve balances rose sharply at the times ofQEI, QE2, and QE3 as the Fed ramped up 

its securities purchases and financed them by creating reserve balances for the banks at the Fed, 

effectively borrowing the funds from banks. Reserve balances tend to drift down after each of 

these surges as currency creation continues its upward march and reduces the Fed's need to 

create reserve balances. 

The increase in reserve balances began before the onset of quantitative easing when the 

Fed set up liquidity facilities to provide lender of last resort loans during the panic in September 

2008.3 However, the need for that liquidity support was temporary, and it dissipated soon after 

the panic, as illustrated in the chart by the line for reserve balances "with liquidity support only." 

That line represents a path for reserves that could have occurred if none of the bouts of QE had 

taken place. Clearly quantitative easing is the cause of the large amount of existing reserves. 

Interest on Reserves 

Such a large increase in the supply of reserves with no increase in the demand for 

reserves has clear implications for market interest rates: The increase in supply would be 

expected to drive down the federal funds rate, which is the rate banks charge each other for the 

overnight use of the reserves. In fact, this is exactly what happened, as shown in the following 

chart for the weeks in fall of 2008. 

billions 

Reserve Balances 

{lett scale) 

percent 

3 The story that the policy of increasing reserves by large amounts started when the Fed's interest 

rate target hit zero is incorrect. The explosion of reserves started on September 17, 2008 when 

the federal funds rate target was 2 percent. The Fed's interest rate target declined from 2 percent 

to near 0 percent over the following months. 

3 
86 


24067.045

As the supply of reserves increased, the federal funds rate was driven down. This decline 

in the interest rate preceded the later decisions of the Federal Open Market Committee to lower 

the federal funds target during this period. Of course, with the supply of reserves now many 

times greater than demand, the market interest rate would remain near zero, unless the Fed took 

some other action, and this is where the policy of paying interest on reserves enters the picture. 

In order to raise the short term interest rate when the supply of reserves is many times greater 

than demand, the Fed has to pay an interest rate on reserves to the banks that is close to the Fed's 

objective for the short term interest rate. That way the banks will bid up the federal funds rate 

(and other short term interest rates) as they see a profit opportunity in the difference between the 

federal funds rate and the interest rate on reserves. The federal funds rate will thereby move up 

close to the interest rate paid on reserves. 

Recent events illustrate how this is supposed to work: When the Fed decided to raise the 

short term interest rate by .25 percentage points at the Federal Open Market Committee meeting 

in December 2015, it did so by raising the interest rate it pays on reserves (required and excess) 

by .25 percentage points effective December 17,2015. The effective daily federal funds rate 

promptly moved up from .15 percent on December 16 to .37 percent on December 17. Looking 

at monthly averages, the rate moved from . I 2 percent in November 20 I 5 to .37 in April 2016. 

This change is consistent with the Fed's "Policy Normalization Principles and Plans" released in 

September 2014 stating that '"During normalization, the Federal Reserve intends to move the 

federal funds rate into the target range set by the FOMC primarily by adjusting the interest rate it 

pays on excess reserve balances."4 

The Financial Services Regulatory Relief Act of 2006 authorized the Fed to pay interest 

on required reserves (the IORR rate) and also the interest rate on excess reserves (IOER rate) as 

determined by the Board of Governors of the Fed. The original effective date was October I, 

2011, but that date was changed to October I, 2008 by the Emergency Economic Stabilization 

Act of 2008, so it was available to be used for the purposes described here. 

The Road Ahead: Normalization 

For many years, including during the period of good economic performance during the 

Great Moderation of the 1980s and 1990s in the United States, the Fed did not pay interest on 

reserves. The interest rate was determined by the supply and demand for reserves. Thus, there 

4 The federal funds rate deviated significantly below the interest rate on reserves in late 2008, 

and, for this and other reasons, the Fed developed back up procedures including overnight 

reverse repurchase agreements to help it control the federal funds rate. However, it appears thus 

far that the increase in interest on reserves may have been enough to move the federal funds rate 

as the Fed intended. In its "Policy Normalization Principles and Plans" the FOMC said that it 

"will use an overnight reverse repurchase agreement facility only to the extent necessary [to help 

control the federal funds rate] and will phase it out when it is no longer needed to help control 

the federal funds rate." 

4 
87 


24067.046

was a direct connection between reserves supplied by the Fed and the interest rate. The short 

term interest rate was market determined once the Fed set the amount of reserves.5 

In contrast, under the current procedures the short term interest rate is not market 

detem1ined. Rather it is administered by the Fed as it makes its decision about what interest rate 

it will pay on reserves. The interest rate on reserves can be moved around by the Fed largely 

independently of the supply of reserves or the size of the balance sheet. The Fed could decide to 

purchase securities or make loans to a certain sector and finance these by increasing reserve 

balances, while not moving the interest rate at all or moving it in a countervailing direction. 

For the reasons explained above, such a disconnect is unavoidable during the current 

period of"nonnalization," as the Fed calls it. The normalization period is essentially a transition 

period between the discretionary era of zero interest rates with quantitative easing and a normal 

period when the interest rate is determined in a more rule-like fashion as it was during the 1980s 

and 1990s. 

Getting back to a normal balance sheet will require that the Fed reduce its securities 

holdings substantially, unless it waits the long time period required for currency growth to create 

a normalization in which case the transition period will be so long it will seem permanent. In its 

September 2014 "Policy Normalization Principles and Plans," the FOMC said it '·intends to 

reduce the Federal Reserve's securities holdings in a gradual and predictable manner. .. ," a 

statement which is an apparent reaction to the taper tantrum of the previous year when the Fed 

was much less clear about its exit strategy. This is an improvement over previous vague 

statements, such as that the Fed will keep "the size of the Federal Reserve's balance sheet at a 

high level for some time," as stated in the FOMC Minutes from the January 27-28, 2009 

meeting, but it could clarify the exit strategy more specifically. For example, the Fed could 

indicate that it will sell securities in the open market at a pace determined by the increases in the 

federal funds rate. I have suggested that the balance sheet be back to normal when the federal 

funds rate hits 2%. In any case, after normalization, when the Fed is back to a normal interest 

rate policy, the interest rate should be determined by the demand and supply of reserves in the 

money market-in other words, by market forces. 

The Road Ahead; After Normalization 

As a long term policy, a disconnect between the short term interest rate and the supply of 

reserves, the money supply or even the size of the balance sheet is a mistake. It enables the Fed 

to be a multipurpose institution-helping one sector or another, taking on credit allocation, 

5 Milton Friedman recommended the payment of interest on required reserves. According to the 

Fed's statement "Interest on Required Balances and Excess Balances," the interest rate on 

required reserves is "intended to eliminate effectively the implicit tax that reserve requirements 

used to impose on depository institutions," which is in keeping with Friedman's rationale. In 

contrast, the interest rate on excess reserves, according to the Fed, "gives the Federal Reserve an 

additional tool for the conduct of monetary policy." 

5 
88 


24067.047

assuming fiscal policy roles the constitution assigned to Congress-rather than the limited 

purpose institution it was designed to be. 

If the United States is to have a selective credit policy with inherent credit risks, it is 

more appropriate for the Treasury or some other agency to take on the job with the approval of 

the Congress with the purposes stated and debated. For the Fed to take on these responsibilities 

raises questions about its independence and its operations, as it may be called on to do such 

things as provide discretionary assistance to financial firms or to bolster the housing market or 

even the student loan market. The success of monetary policy during the great moderation period 

of long expansions and mild recessions was not due to a lot of discretion, but to following more 

predictable policies and guidelines. 

The disconnect would be conducive to more bouts of quantitative easing. There is a great 

deal of uncertainty and disagreement about how effective quantitative easing has been, and it 

may have been counterproductive. I studied the impact of the mortgage-backed securities 

purchase program, which was part of QEI, in research with Johannes Stroebel; we found that the 

purchases were largely ineffective in changing mortgage interest rate spreads once credit and 

prepayment risks were taken into account. Others have found announcement effects of 

quantitative easing on long tenn interest rates, but such studies cannot trace out reversals 

following the announcements. Others have found that the effects are not lasting, unless 

quantitative easing signals future short-term interest rate policy and thus long term rates through 

the expectations model of the term structure.6 

A simple comparison of \-year versus I 0-year US Treasury spreads does not show any 

impact: The spread was 1.3% from 2003 to 2008 before quantitative easing and 2.4% from 2009 

to 2013 during quantitative easing, so other factors must be controlled for. At the least, there 

seems to be a wide consensus that the effect of quantitative easing has diminished over time. 

And there are other problems. Quantitative easing is inherently discretionary rather than rule-like 

and much research indicates that this feature detracts from good economic perfonnance. 7 An 

administered rate can also distort price discovery in markets and prevent money markets from 

6 Studies include John B. Taylor and Johannes C. Stroebel, "Estimated Impact of the Federal 

Reserve's Mortgage-Backed Securities Purchase Program," International Journal of Central 

Banking, 8 (2), June 2012, pp. l-42; Joseph Gagnon, Matthew Raskin, Julie Rema~he, and Brian 

Sack, "The Financial Market Effects of the Federal Reserve's Large Scale Asset Purchases," 

International Journal o.f Central Banking 7, I, 3-44, 20 ll; Arvind Krishnamurthy and Annette 

Vissing-Jorgensen, "The Effects of Quantitative Easing on Long-Term Interest Rates." 

Brookings Papers on Economic Activizv, Fall20 11, pp. 215-65; DanielL. Thornton "QE: Is 

There a Portfolio Balance Effect?" Federal Reserve BankofSt. Louis Review, 2014, 96(1), pp. 

55-72; Michael D. Bauer and Glenn D. Rudebusch, "The Signaling Channel for Federal Reserve 

Bond Purchases," Federal Reserve Bank of San Francisco., 2013. 7 John B. Taylor, "Re-Normalize, Don't New-Normalize Monetary Policy," Macroeconomic 

Review, Monetary Authority of Singapore, Vol. 13, October 2014, pp. 86-90 

6 
89 


24067.048

functioning normally.8 There are also international ramification as central banks tend to follow 

others policies creating international impacts and currency fluctuations that can be destabilizing.9 

Given all these considerations, it is promising that the FOMC says in its "Policy 

Normalization Principles and Plans" that it "intends that the Federal Reserve will, in the longer 

run, hold no more securities than necessary to implement monetary policy efficiently and 

effectively, and that it will hold primarily Treasury securities, thereby minimizing the effect of 

Federal Reserve holdings on the allocation of credit across sectors of the economy." 

Nevertheless, more specificity about the meaning of"efficiently", "effectively" and "primarily'' 

is warranted. In my view, a statement that in the longer run the Fed will pay interest only on 

required reserves and that the federal funds rate will be determined by the supply and demand for 

reserves would help clarify the nature of monetary policy in the normal state following 

normalization. 

Conclusion 

This review of the Fed's balance sheet shows that the current high level of reserves is a 

legacy of quantitative easing in the years from 2009 to 2014. Given that the supply of reserves is 

now many times greater than the demand for reserves, the Fed now has no alternative other than 

to pay interest on reserves as it carries out its normalization process. 

However, as a long term matter, the size and composition of the balance sheet should be 

consistent with the interest rate being market detennined rather than administratively determined 

by the Fed as it sets the interest rate on reserves. It is true-as the FOMC says-that paying 

interest on excess reserves gives the Fed an additional tooL However, this tool enables the Fed to 

be more like a discretionary multipurpose institution rather than the rule-like limited purpose 

institution that has delivered good policy in the past and that can deliver good policy in the 

future. 

The transition, or normalization, period during which monetary policy returns to a more 

normal state should be as short as possible, and, in my view, shorter than currently implied by 

the Fed's "Policy Normalization Principles and Plans." 

Thank you. I would be happy to answer your questions. 

8 Ronald McKinnon: 'The Ncar-Zero Interest Rate Trap," Wall Street Journal, July 29, 2013 9 John B. Taylor, "The Federal Reserve in a Globalized World Economy," in The Federal 

Reserve's Role in the Global Economy: A Historical Perspective, Michael Bordo and Mark 

Wynne (Eds.), Cambridge University Press, 2016. 

7 
90 


24067.049

Statement of David Malpass 

House Financial Services Committee 

Subcommittee on Monetary Policy and Trade 

May 17,2016 

Interest on Reserves and the Fed's Balance Sheet 

Chairman Huizenga, Ranking Member Moore, members of the subcommittee, thank you for the 

invitation to submit a statement regarding the Federal Reserve's balance sheet and the payment 

of interest on reserves. I think the Fed has been hurting growth and causing income inequality 

by misallocating capital to bond issuers. By constantly replenishing its giant long-maturity bond 

portfolio, it biases the credit system in favor of bond issuers at the expense of smaller borrowers, 

notably the small new businesses that are critical to U.S. dynamism. The Fed should change 

direction, including downsizing its balance sheet, reducing its $2.4 trillion in bank debt, reducing 

the interest rate it pays banks, and shortening the maturity of its $4.2 trillion bond portfolio. 

These steps would increase growth and income, especially for the middle class which has seen an 

unprecedented decline in real income during the recovery. 

These steps would also reduce the tiscal deficit, a topic in your February 10 hearing with Fed 

Chair Janet Yellen. Congresswoman Maxine Waters asked Chair Yellen why the Fed has 

decided to more than double its interest payments to banks in 2016 after paying about $7 billion 

in 2015, including more than $121 million to Goldman Sachs and $910 million to JPMorgan 

Chase. The Congresswoman could also have noted that a substantial portion of the Fed's high 

interest payments on reserves are going to the U.S. branches of foreign banks, a drag on U.S. 

taxpayer resources; and that the Fed has cheaper sources of funding than banks. 

Though I'm critical of Fed policy due to its negative impact on growth and median income, I 

want to make clear that I support the Fed as an institution. The problem is that Fed policies aren't 

working. Its concept of its mission has grown way too large and is not sufficiently focused on 

maintaining a strong and stable dollar. It has created a huge balance sheet and regulatory 

apparatus that hurt growth, and it is allowing itself to house inappropriate executive branch 

functions such as the Consumer Financial Protection Bureau. 

In a series of papers beginning in late 2009, I suggested that the Fed's policies would cause 

slower growth by harming the interbank market and misallocating credit to bond issuers. Most 

large borrowers have sufticient access to credit and, since regulators have been forcing a 

deleveraging of the banking system, the grmvth in credit for bond issuers comes at the expense 

of new and small businesses that could better use the available supply of credit. For example, I 

observed in a December 4, 2009 WSJ commentary, "Ncar-Zero Rates Are !IUJiing the 

Economy", that: "Capital is being rationed not on price but on availability and connections. The 

government gets the most, foreigners second, Wall Street and big companies third, with not 

much left over. .. Markets are almost daring the Fed to try to break out of its zero-rate box. But 

for small businesses and new workers, capital rationing is devastating, spelling business failures 

and painful layoffs. Thousands of start-ups won't launch due to credit shortages, in part because 

the government and corporations took more credit than they needed (because it was so cheap)." 
91 


24067.050

The result of Fed policy has been a giant shortfall in income and nominal GDP, with the 

weakness concentrated in lower and middle incomes. Over 75% of U.S. credit growth over the 

last five years has gone to bond issuers. That benefits the government and big companies, but it 

comes at the expense of ultra-low interest rates for savers and less credit for new and small 

businesses. The graph shows the weakness in credit to non-corporate businesses. As a result, 

business investment has been particularly weak, causing devastating reductions in U.S. 

productivity and "potential GDP." Job creation by new businesses has been half its normal rate, 

which is particularly harmful to young workers who often enter the labor force through new 

businesses. 

Debt by Major Sectors (last obs. Dec 31, 2015) 

1B 

16 

"' c l2 

~ 10 ..,., 

8 

0 0 N "' "" 0 N " "' "' 0 •"'< "' "' q.• '2: :c.;> 

~ ~ 9 ;r 9 ! '7 ;;; ~ ~ ~ :s " ~ Iii ~ :!IE :::;: :::;: :::;: :::;: :::;: :::;: :::;: 

Source: Federal Reserve; Encima Global 

Many Arc Challenging Fed Policy 

While Wall Street and Fed-affiliated economists generally support the extreme central bank 

policies (which have strong Fed support and are very profitable for Wall Street), there's ample 

criticism elsewhere due to the weak theoretical support and poor real-world results. 

A July 2015 Fed white paper by St. Louis Fed researcher Stephen Williamson challenged 

the core of the Fed's QE theory. 'There is no work, to my knowledge, that establishes a 

link from QE to the ultimate goals of the Fed inflation and real economic activity. 

Indeed, casual evidence suggests that QE has been ineffective in increasing inflation." 

• In the keynote speech to the Shadow Open Market Committee on April29, Dartmouth 

Professor Peter Fisher, a former Treasury Undersecretary and 15-year member of the 

Fed's staff, directly challenged the premise ofQE: "This generation of economists has 
92 


24067.051

spent their lives working with models of the economy that included the assumption that if 

you lower long-term interest rates both demand for and supply of credit will increase. 

Having assumed thisfor so long, the idea that demand and supply of credit can be 

simultaneously determined (by lower long-term rates) has become part of the macroeconomic belief system. But that does not make it so (italics added) ... (Under) special 

conditions, lower short-term rates and a steep yield curve can, simultaneously and 

strongly, stimulate both the demand for and the supply of credit and create the 

acceleration of aggregate demand that we associate with economic recovery. But to solve 

the zero interest-rate boundary, the Fed decided that flat yield curves not steep ones 

would do a better job. Thus the Fed's mantra was to bring down long-term rates both 

with its balance sheet and its forward-guiding words. Of course, none of us have access 

to the counterfactual. But we do know that flatter yield curves reduce the incentive for 

maturity transformation from what it otherwise would have been." 

• At an April 28 meeting of the Economic Club of New York, the former head of the Bank 

of England, Lord Mervyn King, pointedly criticized central bank policy. He described 

negative interest rates as a wealth tax (by underpaying people for the savings.) He also 

challenged the economic theory that ever-lower interest rates will cause an increase in 

consumption, explaining that people may react to low rates by consuming less. I think 

these criticisms also apply to ultra-low interest rates, which discourage consumption and 

underpay savers, reducing the supply of lendable funds. 

• At a Hoover Institution conference on May 5, during a panel discussion that included 

four members of the FOMC, Professor Allan Meltzer made a formal intervention to 

challenge current policy, citing the staggering lack of business investment. 

The case against the Fed's policy choices isn't new. On September 16, 2010, then-Governor of 

the Bank of Japan Masaaki Shirakawa argued against QE due to Japan's poor results from its 

2001-2006 QE experiment: "We hardly observe the fact that massive expansions in central bank 

balance sheets result in an increase in inflation in advanced economies." With Shirakawa's 

departure from the BOJ after Prime Minister Abe's election in 2012, the BOJ launched a massive 

QE program, buying not only government bonds but also ETFs invested in equities and real 

estate. However, the results have been devastating, creating an almost-continuous malaise and 

below-target inflation. 

Before his death in 2014, Stanford University Professor Ronald McKinnon wrote 

frequently about the hann to economic growth from the paralysis of the interbank market 

(see graph) as the Fed held rates near zero. 
93 


24067.052

Fed Funds and Interbank Loans (last obs. April 29, 2016) 

400 

350 

300 

;;; 250 

"" .. 

c 200 0 

ffi 150 

100 

50 

Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 

Source: Federal Reserve; Encima Global 

• The Fed funds market was once one of the key funding sources for smaller banks, but it 

basically became inoperative. Japan has moved down the same path by causing the 

collapse of its interbank market in February when it reduced its O.l% interest rate to zero 

and below. 

Japan Overnight Interbank Markets (last obs. May 15, 2016) 

25 

0 

'il :::1 

"' ~ ~ ~ 

Source: Bank of Japan; Encima Global 
94 


24067.053

Fed's Balance Sheet Impedes Growth 

In a November 5, 2010 Washington Post oped, former Fed chairman Ben Bernanke explained his 

theory of the Fed buying bonds to lower long-term bond yields: " ... Lower mortgage rates will 

make housing more affordable and allow more homeowners to refinance. Lower corporate bond 

rates will encourage investment. And higher stock prices will boost consumer wealth and help 

increase confidence, which can also spur spending. Increased spending will lead to higher 

incomes and profits that, in a virtuous circle, will further support economic expansion. While 

they have been used successfully in the United States and elsewhere, purchases of longer-term 

securities are a less familiar monetary policy tool than cutting short-term interest rates ... We will 

review the purchase program regularly to ensure it is working as intended and to assess whether 

adjustments are needed as economic conditions change." 

• Since then, the Fed has been projecting fast growth based on the belief that its policies 

will start working. Each year, it has had to slash its forecasts. 

Fed Real GOP Forecast (last obs. March 16, 2016, my estimate for June 15, 2016) 

4.0 

3.5 

0.. 3.0 0 

0 

ro 

e 2.5 

.s 

"' 0> 

c: 2.0 "' .c 

0 

1.5 2011 

1.0 N N N N "' "' (") "' ... "" .,_ ~ ~ 

"- ..,. "- ~ u C: c "- 3 ..,. n C: 

"' o.3 (.) .!>j 0. 0 "' 0. 

< 0 -, < -, 0 < -, 0 -, < 

Source; Federal Reserve; Encima Global 

• QE theories and near-zero interest rates didn't work because they didn't take into account 

the intense regulatory restraint on credit growth. In the past, near-zero interest rates and 

the expansion of the Fed's balance sheet would have facilitated an expansion of private 

sector credit. Though we don't have "access to the counterfactual" as Peter Fisher pointed 

out in his April29 paper- meaning we can't go back and try different policies to see if 

they would have worked better- my view is that GOP growth would have been faster 

and median incomes would have risen, not fallen, if the Fed had allowed the emergency 

monetary policy measures to end and had worked to improve regulatory policy. Instead, 

private sector credit growth has remained dramatically slower in this cycle than in the 
95 


24067.054

previous 50 years- due to a combination of bank deleveraging to meet regulatory 

requirements, the Fed's policy of channeling most credit to over-financed bond issuers 

(e.g. the U.S. government, Apple), and weakness in investment demand that is often 

related to risk decisions by credit regulators. 

Private Sector Credit Growth (last obs. December 31, 2015, 4.4% YIY) 

gJ, 

c 10.0% 

..c "' u 

a< 

> ';;:: 

2.0% 

0.0% 

0 N "' '"' "' 0 N " "' 00 0 N "" "' co 0 

~ ""' "' "" 0 N "' '? '! '! '2 N ~ ~ "!· '? ~ ~ 0 ~ '1' '1' 9 9 '1: '1: '2 "' '2 ;;; .:. i ~ '-

~ ;;; 1\l l;; ;;; ::ii ::E ~ 2 " ~ ~ ::;; "' ::::; " ~ ~ ~ ::;; 2 ~ 2 2 "' ~ ~ 2 ~ 

Source: Flow of Funds- Federal Rese!Ve; Encima Global 

The Fed's balance sheet decisions play a major role in the economic drag. Before 2008, the 

Fed's liabilities consisted primarily of currency. Currency is a very safe, long-term liability 

because it doesn't come due. Against that, the Fed held very liquid assets, primarily Treasury 

bills, making its balance sheet small and ultra safe. 
96 


24067.055

Fed and ECB Assets and Liabilities (last obs. May 4, 2016) 

4.5 

4.0 

3.5 

!':' 3.0 

0 

~ 2.5 

2.0 

1.5 

1.0 

0.5 

0.0 ,_ ,_ 'i' 'i' "' 'i "' 0 

c 

2i ~ ~ ~ 

Source: Federal Reserve; Encima Global 

• As Fed Chair Yellen testified in February, the Fed was borrowing $2.5 trillion from the 

banking system in overnight funding. That's roughly 50% of the Fed's total liabilities. 

Fed Liabilities (last obs. May 4, 2016) 

~ b 

3.00 

2.75 

2.50 

2.25 

2.00 

1.75 

1.50 

1.25 

1.00 

0.75 

0.50 

0.25 

0.00 

Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 

Source: Federal Reserve; Encima Global 

Capital 
97 


24067.056

On the asset side, the Fed exhausted its Treasury bill holdings in 2012 and now holds 

mostly bonds, including mortgage-backed securities and Treasury bonds. In just a few 

years, the Fed's balance sheet has gone from matching a modest amount of relatively 

long-term liabilities with short-term assets, a very safe match; to a burdensome mismatch 

in which a tremendous quantity of short-term, floating-rate liabilities has to support longterm assets. While some of the Fed's assets are liquid, their value fluctuates over a wide 

range as bond yields change. 

Fed Assets (last obs. May 4, 2016) 

2.4 

2.2 

2.0 

1.8 

"' 1.6 c: 

£ 1.4 'G 

<F.> 1.2 

1.0 

0.8 

0.6 

0.4 Federal 

0.2 Agency 

0.0 r- : : - Cf 

s 

' co ' 0) ' 0 c: t Cf c: Cf c: ~ ~ ro ro ro _!. ro _!. -, s -, s -, ::J -, ::J -, -, -, ..., -, 

T -Bills run out 

: -- c: ' 

ro 

-, 

N t (') 

~ c ' 

' ro _!. ro s -, ::J ..., -, ..., 

'<t 

~ 

' s 

-, 

Mortgage 

Unamortized 

Premiums on 

Securities Held 

--· : 

' 1.0 c~ c: ' ro ' ro ..., s ..., ..., Source: Federal Reserve; Encima Global 

Thus, both the quantity of the Fed's bank debt and the extent of its duration mismatch are 

unprecedented. In a leverage-regulated environment, this hurts growth both in terms of the 

quantity and type of credit available. 

• Regarding the quantity of credit, commercial bank balance sheets are limited in size by 

the amount of their equity capital and by regulations regarding their leverage ratios, riskweighted capitalization and liquidity. These credit restraints weren't changed or made 

more effective as the Fed bought bonds, meaning the Fed's increase in liabilities to the 

banking system forced reductions in the other assets of the banking system. Fed Chair 

Yellen testified in February that the Fed has drawn as much as 20% of the assets of the 

entire banking system. 

• A second part of the Fed's balance sheet drag is due to its duration mismatch. Banks 

have had to reduce up to 20% of their assets to make room for the Fed, but the question 

is: which assets and what is the growth impact? In practice, as the banking system 

supplied short-term liabilities to the Fed, it reduced its other short-term assets, putting a 

priority on maintaining its maturity structure. To oversimplifY, if the banking system 
98 


24067.057

sold a long-term bond to the Fed in return for a short-term deposit at the Fed, it tended, 

over time, to reestablish its previous maturity structure. This meant reducing its other 

short-term assets (for example, by not renewing a small-business loan unless it could 

obtain a personal guarantee) and increasing its long-term assets (for example, by 

increasing its real estate loans or bond holdings.) Bank lending surged and U.S. GDP 

growth accelerated to over 4% in mid-2014 when the Fed was tapering its bond purchases 

and signaling the intention to taper its reinvestments and its bank borrowing (by 

expanding its repo borrowing.) 

• We often hear that slow credit growth is due to insufficient demand, i.e. secular 

stagnation. But it's also insufficient supply for the type of borrowers that have credit 

needs. Supply and demand have to intersect in order to create transactions. For many 

potential borrowers, the loan terms are too onerous (e.g. personal guarantees for a small 

business loan but not for a bond offering.) The mix of credit would have been different 

(more growth oriented) if the supply of credit had been more receptive to small and new 

businesses- either because of higher interest rates available to lenders or less bias in 

favor of bonds. For example, in the current system, the credit-worthiness of federal, state 

and many local governments is given a huge regulatory advantage over the private sector, 

especially small business. This reduces private sector investment and the related 

productivity growth. Government bond offerings have much more lenient rules than 

private sector issuers- incomplete disclosure of projected pension outlays, misstatement 

of unfunded liabilities (as in Illinois), questionable reliance on contracts (as in the Puerto 

Rico's bonds), related-party transactions (as with the Detroit muni bonds owned by 

Detroit public pensions.) The result is that potential growth-oriented borrowers don't get 

credit while lenders feel that demand from small borrowers is insufficient and turn 

instead to bonds. 

The Fed's Growth Options 

In addition to the desperately-needed regulatory improvements, the Fed has several immediate 

growth options related to its balance sheet: 

l. The Fed could taper its reinvestment, allowing its bond holdings to gradually decline. 

The extra cash from maturing principal would be used to reduce excess reserves, 

reducing the Fed's bank debt. That would leave commercial banks holding lendable cash 

and non-banks holding the newly-issued Treasuries (the ones the Fed would have bought 

if it were fully reinvesting.) Assuming banks would seck to maintain the size of their 

balance sheets, they would lend some of the idle cash in the fed funds market, lend some 

through government securities (to meet liquidity requirements and earn interest), and they 

would lend more to businesses too. 

2. The Fed could buy shorter term bonds during its reinvestment process. This would 

reduce the heavy bias favoring bonds, allowing a more growth-oriented mix of credit. 

More credit would flow to smaller businesses, increasing growth, investment and median 

income (since much of the benefit of the inflated bond issuance flows to upper incomes at 

the expense of median incomes.) 
99 


24067.058

3. The Fed could reduce the interest rate it is paying banks. For example, it could pay banks 

0.35% now rather than 0.5%. This has several attractions. It would reduce the fiscal 

deficit directly. If banks reduce their reserves (because of the Fed's reduction in interest 

rate payments), the Fed could shift the mix of its liabilities toward the reverse repo 

market, available to the Fed at 0.25%. This has the advantage of further reducing the 

fiscal deficit and causing banks to lend to other borrowers (than the Fed.) It's 

possible/likely that a reduction in the lOR would increase bank lending in the fed funds 

market. It should also increase bank lending for working capital, one of the most 

productive types of credit in the economy. 

Various Short-term Interest Rates (last obs. May 4, 2016) 

0.70 Interest on Excess Reserves 

0.60 

0.50 

% 0.40 

0.30 

0.20 

0.10 

0.00 ,. 

7 "' 7 "' 7 

~ a ~ < 

Source: Federal Reserve; Encima Global 

Interest on Reserves 

3mo 

Tbill 

When the Fed increased the Fed funds rate in December 2015, it decided to increase the lOR 

from 0.25% to 0.5% and to offer to conduct reverse repo borrowing at 0.25%. The volume in the 

latter market has been limited, in part because the IOR is too high. In a March 2015 paper, "The 

Fed Should Fix the Interest on Reserves Floor," Marvin Goodfriend of Carnegie-Mellon and 

formerly of the Richmond Fed describes the Fed's revisions to its thinking on the IOR. In its 

original concept, the Fed thought the lOR would function as a floor on the Fed funds rate. As 

Goodfriend describes the June 2009 FOMC transcript: 'The Fed (had) planned to employ the 

interest on reserves floor as the primary means to exit the zero interest bound and tighten 

monetary policy without first shrinking its balance sheet and creating a scarcity of reserves. But 

there was a problem: ... the federal funds rate regularly traded 50 basis points or more below 

interest on reserves." By the FOMC's September 17, 2014 statement on "Policy Normalization 
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Principles and Plans," the Fed had decided that it "would set its rate for ON RRPs at or slightly 

below interest on reserves as it normalizes interest rates." 

At the December 2015 rate hike, however, the Fed set the rate on the repo facility (the ON RRP) 

a full25 basis points below the IOR, not the 2014 decision to set it "at or slightly below IOR". 

This leaves the Fed overly-dependent on bank debt. I think the spread between the ON RRP and 

the IOR should be 10 or 15 basis points in keeping with the 2014 policy statement. This would 

save the taxpayer billions of dollars and allow a diversification of the Fed's liabilities into the 

repo facility. 

In his 2015 paper, Dr. Goodfriend objects to the repo facility, saying it would be "violating an 

implicit principle of central banking in the United States--that where possible the central bank 

should minimize its interference in financial intermediation and credit allocation in managing the 

monetary system." I agree with that principle as a concept, but the Fed has given it up 

completely by interfering in long-term interest rates, manipulating tl1e dollar, freezing the 

interbank market and arbitrarily deciding on high interest payments to banks. For now, the 

priority should be to encourage the Fed to reduce the damage from its bank debt. 

In conclusion, we should recognize that economic theory is not a perfect science and that the Fed 

can make mistakes and miscalculations. In the 1970s, the Fed propounded a theory that holding 

interest rates down would reduce inflation. Instead, it weakened the dollar, causing prices to 

rise. In the 2000s, the Fed kept interest rates well below market levels on the theory that 

inflation risks were less risky than deflation risk and that bubbles couldn't be identified in 

advance. It decided to limit its rate hikes to only 0.25% per FOMC meeting, contributing to 

dollar weakness, the housing bubble and the financial crisis. The current policies have been 

questioned since 2009 on the view that they help larger borrowers but hurt median incomes and 

growth. It's clear that growth and median income gains during the current expansion have been 

much less robust than in previous expansions, inviting fundamental changes in Fed policy that 

would favor growth. 

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