Ending Interest on Reserves Won’t End Bank Welfare—But It Will Boost Inflation

Later this morning, the Senate Committee on Homeland Security and Government Affairs (HSGAC) will be holding a hearing on the Federal Reserve’s (Fed’s) policy of paying of interest on reserve balances (IORB). The title of the hearing—“The Fed’s Big Bank Welfare Program: Oversight of the Fed’s IORB Regime”—signals Chairman Paul’s framing of the issue.

But would ending those payments actually eliminate “bank welfare”? As my Mercatus colleague David Beckworth has explained, the answer is:

Not really. For a given level of liquidity demand, banks would simply shift from holding reserve balances to holding Treasury bills (T-bills) if reserves no longer earned interest. The payments from the federal government to banks would continue, just in the form of interest on T-bills rather than interest on reserves.

In that sense, eliminating IORB would be largely a wash in terms of federal payments to the banking system—unless the IORB rate has been systematically higher than T-bill yields. Only when the Fed pays banks more on reserves than they could earn holding comparable risk-free assets like T-bills can one view it as a taxpayer-funded subsidy.

David shows that the IORB rate has indeed exceeded T-bill yields, but only slightly—about 20 basis points on average. Even so, eliminating IORB would hardly eliminate payments to banks.

That’s an important fact to keep in mind. But there’s another question policymakers don’t seem to be asking: In a high-inflation environment (like the one we still live in), what is the purpose of IORB? The answer: to combat inflation.

By holding reserves, banks choose to reduce liquidity, which restrains the money supply. Eliminating IORB would encourage banks to move those funds back into the market. They could buy government debt, temporarily lowering interest rates, or lend to productive investments—but in either case the effect would be inflationary. And we must remember that each dollar returning to circulation has a multiplier effect, expanding the money supply by more than the initial change in reserves.

As I explained in a policy brief earlier this year, updated with today’s figures:

Assuming the current money multiplier of [4.1] remained unchanged and that all reserves returned to the market, the result would be an almost $1[2] trillion (or 5[3] percent) increase in the money supply. However, the reduction in reserves would likely cause the money multiplier to increase. Realistically, if all reserve balances were eliminated, the multiplier could return to (or even exceed) the pre–Great Recession level of about 9.0. This would instead mean an increase of over $[26] trillion to the money supply—more than doubling the money supply and potentially causing the price level to more than double.

This doesn’t mean eliminating IORB isn’t a worthwhile long-run goal. It can be if paired with disinflationary measures, such as a reduction in the Fed’s balance sheet, to prevent a resurgence of inflation. Unfortunately, as my colleague Jack Salmon, recently discussed, the Fed just formally ended its quantitative tightening policy—and, earlier today, cut rates yet again.

The disinflationary policies needed to accompany Senator Paul’s preferred outcome simply aren’t there. And in the current political environment, it doesn’t look like that will change any time soon.