Unlock the Editor’s Digest for free
Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
Last year, Reform UK came up with a cunning wheeze to scrap the Bank of England’s ability to pay interest on reserves, saving £35bn. Readers may recall our big explainer on central bank reserve frameworks that kicked the tyres of the idea.
Over in America they do everything bigger. Four minutes and 47 seconds into this CNBC interview, Texas senator Ted Cruz drops his bomb:
The Federal Reserve pays banks interest on reserves. For most of the history of the Fed they never did that. But for a little over a decade they have. Just eliminating that saves a trillion dollars.
A trillion dollars 😮
Is this free money just sitting there for the taking?
According to Barclays, the Fed paid $176bn in Interest on Reserve Balances and another $104bn in interest expense operating the Overnight Reverse Repo Facility in 2023. This $280bn total expense would — in more normal times — be more than covered by interest income from the asset side of their balance sheet.
But the asset side of their balance sheet consists largely of mortgage-backed securities and US Treasuries purchased when yields were ultra-low. So the interest income from these holdings doesn’t offset the cost of paying reserves. Net-net, the Fed has been running negative net interest income of $80-100bn over the past couple of years.
Let’s not be sniffy about these numbers. One hundred billion dollars is a lot of money. In fact, 10 years of $100bn gets us to a trillion dollars. But, as a new note from Samuel Earl and Anshul Pradhan at Barclays reminds us:
These losses the Fed generates from having interest expenses greater than interest income do not impact the deficit as they are recorded as deferred asset on its balance sheet. However, the deferred asset would need to be paid off before the Fed resumes its remittances to the Treasury.
Of course — the deferred asset.
The UK — somewhat inexplicably — flushes all negative net income on QE, as well as all realised losses attached to QT, through the current year’s fiscal accounts — so passing large fiscal decisions directly to the MPC. The US, in line with loads of other central banks, does not:
As such, it’s not that net interest and valuation losses are funded by the US Treasury. It’s more that seignorage — the profits from running the central bank for what is still the world’s reserve currency — are no longer remitted to the Treasury until all the losses generated by QE and QT have been paid off.
But Cruz is right — before the global financial crisis the Federal Reserve didn’t pay interest on reserves. Surely we can just rewind the clock?
Reserve scarcity
Today there are $3.3tn of central bank reserves in the Federal Reserve system. Back in 2006, there were only $10bn. The Fed required banks to meet minimum reserve requirements (since scrapped), and by fine tuning the supply of reserves in open market operations the Fed could pretty much control the policy rate.
What would happen if the Fed were to return to a scarce reserves framework? Barclays:
The problem with this framework is that it inextricably links the rate policy with the balance sheet policy. That means that the Fed can not provide emergency liquidity without impacting the supply of reserves and thereby potentially requiring a sterilization in order to keep policy at target.
We think that to get from where we are to where Cruz seems to want us to be would require a very rapid pace of substantial quantitative tightening. Literally trillions of assets would need to be sold, and any realised losses on these sales would of course be added to the Fed’s deferred asset — precisely the thing that is preventing the resumption of seignorage remittances that appears to be Cruz’s end goal.
Furthermore, according to Barclays:
This essentially means the Fed can not run a large balance sheet at will, and would be constrained from providing emergency liquidity lest it loses control of its policy rates.
This all might suit liquidationistas just fine. And there is active support in Congress to simply abolish the Fed altogether. But to us, kneecapping the central bank’s ability to both control policy rates and serve as lender of last resort sounds … bad?
Reform UK are sometimes accused of aping the MAGA movement. Maybe the intellectual traffic is a bit more two-way than we’d appreciated.
Leave a Reply