Karen Shaw Petrou’s memorandum to the Federal Financial Analytics clients on why IOER isn’t a subsidy and why this matters so much?

TO: Federal Financial Analytics Clients

FROM: Karen Shaw Petrou

DATE: December 11, 2015

Monetary policy lift-off doesn’t just mean a fed funds rate hike – with it also comes a parallel increase in interest on excess reserves (IOER). These payments to Fed members will thus grow to at least $13 billion early next year, sparking growing political complaints about a new big-bank subsidy. Mentioning the Federal Reserve, big banks, $13.4 billion, and “subsidy” in a single sentence cannot fail to catch political fire, if only because it’s so much money that Members of Congress will surely lay hungry eyes on it during an election year. The problem, though, isn’t that IOER is a big-bank subsidy – it isn’t. The problem is far more fundamental – the FRB has to pay out such big bucks on excess-reserve holdings because its traditional, bank-centric monetary-policy transmission tools don’t work in the new financial market where banks don’t matter anywhere near as much as they used to. Meddle with IOER, mess up what’s left of the Fed’s ability to execute monetary policy, and throw an already fragile exit strategy into the abyss.

As we noted in a series of client alerts, the FRB knows this. It thus recently convened a high-profile conference on exactly this question: why monetary policy isn’t moving through the markets as theory would have it and what can be done about it. In the course of this conference, several Fed and academic experts looked not only at IOER, but also at a new tool the Board has had to construct due to its inability now to rely on traditional bank reserve and interest-rate transmission channels: the reverse-repo program (RRP). Although banks are in some instances eligible RRP counterparties, the program is built principally with MMFs and GSEs in mind. Without them, the Board knows it can’t normalize its huge books of assets without running the real risk of triggering an avalanche of unprecedented money-market volatility.

Although the scope of quantitative-easing normalization is unprecedented, banks might arguably have been able to handle it and IOER to manage any disruptions if big banks were major market makers. Since they aren’t, the FRB can’t count on them and thus now does business – a lot of it – with non-banks.

One of the “subsidy” arguments is predicated on the difference between the rates the FRB pays on IOER and those on offer to non-banks in the RRP. Because IOER is higher than the RRP rate, the subsidy complaint says that big banks get more than they deserve. However, the argument misses the fundamental distinction between IOER and the RRP – the FRB had to build the RRP as a floor under IOER so there is a meaningful floor under the fed funds rate. Without a meaningful floor, the U.S. would have quickly slid into nominal negative rates – a dangerous proposition as a recent FedFin paper makes clear. Given the role of non-banks, IOER can’t be the floor and the RRP is thus also essential.

The subsidy rationale suggests that the RRP rate and IOER could be the same and a floor still stand beneath the Fed’s needs. However, this is to ignore the fundamental function the RRP plays – a money-market channel in which banks and non-banks arbitrage their relative roles and regulatory frameworks to create demand for the RRP that then ensures it supports IOER and FOMC rate objectives. The interaction between a lower RRP rate and a higher IOER one thus has nothing to do with subsidy and everything to do with a desperate Fed effort to arbitrage the relative needs of banks and non-banks to support its exit strategy. If anything, banks need to get a higher IOER than non-banks precisely because all the rules imposed on them cost so much, making it impossible for them to handle the transaction volume FRB tapering demands.

If Congress messes with this already very fragile architecture by sopping up IOER, it would leave the FRB with nothing but the RRP which would force the FRB quickly to become the globe’s very biggest financial institution making the very biggest bets in the U.S. money market. Without banks as a policy intermediary and given all the risks and limitations of non-banks, the FRB would be forced to become the largest counterparty of them all – not exactly what Fed critics seeking to cut it down to size have in mind for the U.S. central bank.

Why IOER Isn't A Subsidy And Why This Matters So Much?