Editor's Note: This is a Hedgeye Guest Contributor piece written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.
The Fed adopted a policy of paying banks interest to hold reserves (required and excess) in 2008. This policy was based on the idea that if the Fed paid banks interest to hold reserves, banks would hold the excess reserves created by the Fed’s large-scale-asset-purchase program, known as quantitative easing (QE), rather than make loans with them. The Fed believed that IOR would prevent its QE policy from increasing the money supply. No one anticipated that this policy would cause the Fed to incur a large and growing debt to the Treasury.
As of December 2022 the Fed has paid banks $216 billion. The amount the Fed has been paying banks has increased since the Fed began raising its target for the federal funds rate because the IOR rate increases in lock-step with increases in the Fed’s policy rate. The Fed has paid banks nearly $75 billion in just the past four months.
Because the Fed has been giving banks such a large amount of its income over expenses, it has been unable to rebate its excess income to the Treasury as it has done historically. Instead, the Fed has been incurring a debt to the Treasury since September 7, 2022. As of February 2, 2023, the Fed owes the Treasury $251 billion, of which $120.4 billion has accrued between January 4 and January 25, 2023.
The Fed’s debt to the Treasury and the amount of money the Fed gives banks will continue to grow if interest rates remain high or go even higher. The Fed increased the IOR by 25 basis points at its February meeting and is poised to raise it higher before the year’s end. What the Fed does in the coming months is dependent on the path inflation takes. There are signs that the inflation rate is coming down, but as I pointed out in a recent op-ed published in The Hill, the path that inflation will take is very difficult to predict.
In May 2022, the Fed announced that it was going to start shrinking its balance sheet and estimated the Fed’s holding of securities will decline by $2.6 trillion by mid-2025. As the Fed reduces the amount of securities it holds, its income will decline too. The Fed will have less income to pay banks, so its debt to the Treasury is likely to grow even faster. It is even possible that the Fed won’t be able to meet its IOR payments to banks.
IOR has implications for the national debt. The Fed has already paid banks $216 billion that otherwise would have been rebated to the Treasury. It is likely that the Fed will give banks at least $300 billion more by the year’s end; all of which could have been rebated to the Treasury.
Instead, the Fed’s debt to the Treasury will continue to grow. Given the likelihood that IOR will remain high and that the Fed’s income will decline, it is not difficult to imagine that the Fed’s indebtedness to the Treasury could be very large by the end of this year. The Fed’s debt to the Treasury increased by $120.4 billion since December 28, 2022, so it is not a stretch to believe that the Fed’s debt to the Treasury could be $1.5 trillion by the end of the year.
It will take a very long time for the Fed to pay off a $1.5 trillion debt to the Treasury. During the period from January 5, 2011 to September 7, 2022, when it started going into debt to the Treasury, the Fed rebated $1 trillion to the Treasury. This was a period when the interest rate the Fed was paying banks was relatively low and the Fed’s income from its large holdings of securities was high.
These problems can end relatively quickly if the Fed ends its IOR policy. Furthermore, doing so won’t have any adverse consequences for either the Fed’s economic policy or the economy. In a paper I published in the Cato Journal, and The Fed's Other Folly I showed IOR would not prevent banks from making loans from excess reserves. Specifically, I pointed out that: a) banks have an incentive to make loans with the lowest cost funds, and b) banks will always have loan opportunities that pay risk-adjusted interest rates higher than the IOR. Given these facts, all that remained was to demonstrate why excess reserves would nearly always be the lowest cost way for banks to finance their lending.
The fact that M1 increased by $2.5 trillion from November 2008 to December 2019 compared with $1.5 trillion over its entire previous history is sufficient to show that IOR did not prevent banks from making loans from their excess reserves as the Fed believed it would.
I didn’t anticipate that the Fed’s IOR policy would eventually cause the Fed to become indebted to the Treasury. However, my analysis demonstrates that there would be no adverse consequences if the Fed ends this ill-conceived and completely ineffective policy. If it doesn’t, these problems will worsen and be with us for a long time.
