The Confused Fed - Vested - Milton Ezrati, Chief Economist

The Confused Fed

Recent statements from two prominent figures at the Federal Reserve appear to contradict each other.

On one side, Boston Fed President Eric Rosengren forecast a powerful economy during this year’s second half, driven by widespread vaccinations and a complete lifting or quarantines and lockdowns.  On the other side and almost on the same day, St. Louis Fed President James Bullard announced a need for continued easy monetary policy for the foreseeable future to support a weak economy.  It is only reasonable to ask, what does the Fed believe?  Will the economy roar back, or will it need support?  

Actually, it matters little these days what the Fed thinks.  A review of Fed policy for the past few years reveals that leadership at the Fed going all the way back to Chairman Ben Bernanke during the financial crises of 2008-09 has so muddled its policy that what on the surface seems like monetary support for the real economy has done little to promote real growth.  Short of sorting out this muddle or turning to truly radical policies – neither especially likely – the economy’s recovery will occur regardless of Fed actions and aside from the support Bullard seems to think the Fed can provide.

If a misguided policy mix has rendered the Fed impotent to affect the real economy, the problem begins outside the Fed in the country’s regulatory institutions.

An exceedingly cautious regulatory climate has developed in Washington, understandable given the destructive power of risk taking so evident in the 2008-09 financial crisis.  But however much these regulatory efforts have protected the financial system, they have also blocked the flow of credit to the real economy.  

Take the Dodd-Frank financial reform legislation.  It actually penalizes banks that lend to business, especially small businesses.  Because such lending carries greater risk than, say, buying government securities, the law insists that each time banks make such loans they set aside more capital than otherwise.  Since that capital earns next to nothing, the rule effectively denies the banks the high returns that they otherwise would get from lending to small businesses and individuals.  The rule actively discourages such lending.  At the same time, the law orders the Fed to impose “stress tests” on the banks  Any risky loans – like those to small businesses and individuals – make the banks look less stress resistant and accordingly loses them points on these tests.  Since the Fed publishes the results of the tests, banks designated as having low stress resistance tend to see the value of their stocks fall, another reason for them to avoid lending to what the media once referred to as “Main Street” but seem these days to prefer the “kitchen table” metaphor.  Though policy makers must see the effect, Congress seems to prefer playing it safe instead of taking the risk involved in allowing banks to actually make the loans that support economic growth.  

The rest of the Fed’s problem – the bulk of it — lies within its own policy mix.  This great muddle began in 2008 when the Fed decided to mimic the Europeans and pay interest on the reserves that banks keep with the Fed as backing for their lending. 

These interest payments constitute a strong temptation for banks to leave money idle in deposits at the Fed instead of using it for lending to businesses and individuals.  Before the Fed began to pay interest on reserves, banks made a thorough use of the reserves they had to support such lending.  They held only so much in these Fed accounts as regulations required.  The rest, banks eagerly lent out to individuals and businesses large and small to finance spending on new equipment, the latest technologies, and hiring.  But now a big portion of these reserves remain idle.   

The Fed’s own accounting gives ample evidence of the extent of this problem.  Prior to 2008, banks held almost no reserves in excess of the amounts legally required by the regulators.  Since this interest-paying practice started, reserves held back from lending have risen astronomically.  As of the most recent available data, some 93 percent of in the reserves held by banks at the Fed exceeded required amounts. It has been a good deal for the banks. They have received a return on what is essentially a risk-free investment.  But for others, the arrangements have not been so good. Every dollar held back in this way has denied credit to the businesses and individuals that move the economy.

Policy makers hinted at some recognition of the problem a few months ago, when they brought the rate paid on reserves below what banks can get from low-risk lending elsewhere, but mostly Fed policy makers, rather than end the practice, have tried to get the desired economic response by bypassing the banks and injecting liquidity directly into financial markets.  This practice of buying government and corporate bonds on the open market, what the Fed calls “quantitative easing,” has also failed.  Rather than reaching “Main Street,” where this torrent of money could have stimulated economic activity, the liquidity the Fed has added to financial markets has stayed there and bid up the prices of financial assets quite aside from what was happening in the general economy.  It would overstate to say that the gains in financial assets have come at the expense of actual hiring and building.  The reality is rather that the Fed has (no doubt inadvertently) helped financial people while failing to increase money flows to the real economy.

And this is not all.  The Fed’s preference for using near-zero interest rates to stimulate economic activity has also had its perverse effect.  

The reasoning behind this move in part holds that by reducing to nothing the cost to banks of collecting deposits, they will lend more freely and at more attractive rates to borrowers, individuals, for instance, who want to make a big-ticket purchase or businesses that want to expand.  This fits well with economic theory, but in practice the policy has made it especially attractive for banks to buy government paper instead of making these kinds of economically important loans.   

To see this effect, compare today’s rate relationships with how things were only two years ago.  Then, banks paid an average of about 1.3 percent to gather deposits, less on checking accounts and more on certificates of deposit, which secure the funds for longer periods of time.  They earned 2.46 percent on a 10-year treasury note, about 1.16 percentage points more than cost, an 89 percent return on that cost.  Today, banks pay on average 0.09 percent to collect deposits.  They get about 1.1 percent on a 10-year bond, a seemingly tiny number but over 1,000 percent return on those low costs.  Little wonder, then, that the banks prefer lending to the treasury over lending to small businesses.  They not only earn an outrageous premium over cost, but they take no credit risk and win points from regulators for playing it safe. 

These preferences show clearly in the mix of bank assets recently reviewed by The American Banker.  The 25 largest banks in the country have seen a massive $1.3 trillion inflow of deposits since last February.  They have used almost all of it to add $1.1 trillion to their holdings of cash and securities guaranteed by the federal government, mostly treasury notes and bonds.  Treasury paper now constitutes some 35 percent of their assets, well above the 5-year average and the biggest proportion of assets since record-keeping started in 1985.  At the same time, a survey conducted regularly by the Federal Reserve indicates that banks have significantly tightened their standards for lending to small businesses and individuals.  

Though the data speak clearly, the Fed seems unaware of the problems or unconcerned by them.  Perhaps the banks have lobbied the Fed to continue its practices.  Last month’s reports on powerful earnings at banks large and small show how profitable they have become under Fed support without having to deal with the messy world of “Main Street” or the “kitchen table” or whatever expression one uses to refer to the real world of business outside Washington and off Wall Street.  Whether Bullard or Rosengren are correct about the economy and its needs, until these elite policy makers clear up the muddle they have made for themselves, the Fed’s position will remain of little importance to the real economy.

A greater impact on savings and investment would emerge from Biden’s plans on capital gains and inheritance taxes

He would raise the present rate of 23.8 percent to 39.6 percent for households with annual incomes above $1.0 million.  He would change current arrangements on inheritance.  Today, those willed appreciated assets pay taxes only when they realize the gains and then only on the gains since they received the assets.  The Biden plan would insist that heirs pay income taxes on the unrealized gains.  These plans are silent on other aspects of inheritance taxing, such as the $100,000 exclusion per person or accommodations for inflation or special provisions for the transfer of a principal residence or a small family business or farm. Presumably, these would stand.

We’re such provisions to pass into law or even just look likely, they would cause an immediate sell off in financial markets as asset holders sought to realize gains under the present lower tax rate.  Such monies would likely go back into the market quickly.  The inheritance changes would have a more lasting depressive effect on market prices in that each transfer would force sales to enable the heirs to pay the tax on the willed assets.  In general, the provisions would discourage savings by significantly reducing the returns to them, putting further downward pressure on asset prices and otherwise reducing the funds available for capital investments.

A strict accounting of these the entire package shows that it would raise federal revenues some $3.3 trillion over ten years.  Accounting  for the slight growth impediment in these tax changes, a consensus of economists suggests that the actual revenue gain would amount to something closer to $2.7 trillion over this time.  Either way, the annual figure of between $270 and $330 billion would reduce projected federal deficits by about a third, leaving considerable flows of red ink.  Of course, the ultimate budget effect would also depend on Biden plans for spending, which are far from inconsiderable, especially his version of the Green New Deal.  How much of that passes into law will also be a matter of substantial resistance in Congress and will form the subject of a separate discussion.

Recent Case Studies

Back To Blog