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Fed Must Stop Rewarding Banks for Not Lending

Norbert Michel and George Selgin

Federal Reserve officials are beginning to call for shrinking the central bank’s bloated balance
sheet. That’s good news. Doing so reduces taxpayer risk, and undoes
the Fed’s massive allocation of credit to its preferred sectors,
government and housing. This will close a chapter on one of the
most controversial periods in the Fed’s history. The bad news: If
the Fed doesn’t simultaneously stop paying banks to hoard money,
the Fed will create the next recession.

During the financial crisis, the Fed put its traditional tools
of monetary control on ice, and switched to experimental ones. One
of those new tools, paying interest on excess reserves, started in
October 2008. It encouraged banks to park money at the Fed instead
of lending to businesses and households.

What drove Fed officials to discourage lending in the throes of a financial
meltdown? It was an especially odd move given that the Fed was
concurrently making so-called emergency loans to keep financial
institutions afloat. But Fed officials feared that unless they got
banks to hoard the fresh reserves created by their emergency
lending, the flood of extra dollars would send the federal funds
rate to zero – well below their 1.5% target.
Influencing the federal funds rate was traditionally one of the
Fed’s key methods for controlling the growth of credit and meeting
its employment and inflation goals.

The experiment failed dramatically. The federal funds rate
dropped toward zero anyway.

The balancing act won’t
be easy, but it’s both possible, and worth it.

The Fed did succeed, however, in getting banks to sit on those
fresh reserves, curbing new loans banks would typically make when
fresh deposits show up. It was thanks to interest on excess
reserves that the Fed ended up stimulating so little in the
economy, despite its efforts to ease so much.

The new policy appeared intended to enhance the Fed’s
traditional methods of monetary control. But in fact, it rendered
those methods almost entirely impotent.

Returning to “normal” monetary policy means undoing all
of those changes that made old-fashioned monetary policy
ineffective in the first place. Shrinking the Fed’s balance sheet
isn’t enough. In fact, on its own it’s dangerous. If the Fed keeps
paying banks not to lend at the same time it starts slimming its
balance sheet, we could be in for very tight money.

In 1936, the Fed faced a similar situation. Fearing an outbreak
of inflation, the Fed responded by raising banks’ legal reserve
requirements. But, like today, banks wanted those big reserve
cushions. To keep them, they clamped down on credit. The outcome
was the notorious “Roosevelt Recession.”

Another recession is the last thing this economy needs. But if
the Fed sticks to its present normalization plan, that is exactly
where we are headed.

To normalize without inviting a new recession, the Fed needs to
combine its plan for shrinking the balance sheet with one for
phasing-out interest on excess reserves.

Shedding assets tightens credit, but discouraging banks from
holding reserves loosens it. By doing both at once — reducing
assets and lowering interest on excess reserves — the Fed can
keep money from becoming either too loose or too tight.

The balancing act won’t be easy, but it’s both possible, and
worth it.

Oddly, the Fed has been moving in the opposite direction,
raising the interest rates it pays banks and other financial
institutions to keep excess reserves. And the public, having had
its fill of “low interest rates,” has been buying it as a step in
the Fed’s “normalization” plan. But so long as the Fed encourages
banks to hoard money, it is not returning to the pre-crisis
approach of monetary policy.

During the financial crisis the Fed ran many risky monetary
policy experiments. One set of experiments added trillions of
dollars of fresh reserves to the banking system and distorted
credit markets. Another encouraged banks and other financial
institutions to hoard those reserves, instead of lending or
investing them.

Just how helpful these experiments were in ending the crisis, or
promoting recovery, remains unclear. Only one thing is certain: If
we want “normal” monetary policy without creating a recession, the
Fed must shrink its balance sheet andstop paying banks not to
lend.

Norbert Michel is a senior research fellow in financial regulations and monetary policy at the Heritage Foundation. George Selgin is director of the Center for Monetary and Financial Alternatives at the Cato Institute.