Monetary policy has the Federal Reserve on a collision course the American taxpayer. Not only does the Fed pay banks to keep them from lending to businesses and consumers, the Fed’s interest on reserves policy has taxpayers subsidizing large domestic and foreign banks. A simple fix will shift interest on reserves payments from banks to taxpayers and simultaneously enhance the Fed’s ability to control interest rates. The solution is for Congress to create new mutual fund that earns Fed interest on reserves payments.
As the Fed tightens monetary policy, the current interest on reserves rate of 1.25 percent will increase. Higher interest on reserves rates will increase the Fed’s interest expense and the federal budget deficit. In 2016, the Fed paid $12 billion in interest on reserves. In August, banks held $2.34 trillion in reserves. If the rate is unchanged, banks will earn more than $29 billion annually on these balances. About half of interest on reserves payments go to the largest U.S. banks and a third go to foreign banks. Only a tiny share of interest on reserves is passed through to U.S. business and consumers in the form of higher bank deposit rates.
Today, the federal funds rate trades in a range between two rates set by the Fed: the interest on reserves rate and the rate the Fed pays on reverse repurchase agreements. These are the rates the Fed pays to borrow banks’s and other intermediaries’s reserves. The Fed has no direct investment use for these reserves. When banks lend reserves to the Fed, they cannot lend them to consumers and businesses. Because of the massive surplus of reserves created by its crisis-fighting policies, the Fed must now use interest on reserves and reverse repurchase agreements to set the federal funds rate and control bank lending growth.
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