The media are focused on fiscal policy failures—namely, the fight over a second Covid economic-relief bill. They should be paying much closer attention to monetary policy.
The neglect is due to the long-running sense that, with interest rates down nearly to zero and financial markets flooded with liquidity, monetary policy has done all it can to spur growth. But a closer look at Fed policy and practice shows why the central bank’s efforts to stimulate economic activity have fallen short. It can still fix the problem.
As a first step, the Fed should abandon its still relatively new practice of paying interest on the reserves it holds for banks. First adopted in 2008 in imitation of Europe, where the practice also distorts policy effects, these payments tempt banks to leave money idle in deposits instead of using it to lend funds to businesses and individuals. Before the Fed began paying interest on reserves, banks made a thorough use of their reserves to support such lending. They held only as much in these accounts as regulations required, eagerly lending the rest to individuals and businesses, large and small, to finance spending on new equipment, the latest technologies, and hiring.
The Fed’s own accounting gives ample evidence of the extent of the problem. Prior to 2008, banks possessed minimal reserves. Since then, reserves held back from lending have risen astronomically. Over the last 12 months or so, 91 percent of funds held by banks at the Fed exceeded required amounts. Money held back this way means credit denied to the businesses and individuals that move the economy.
Though the data speak clearly, the Fed seems unaware of the problem. Perhaps the banks have lobbied it to continue the practice. The Fed gave a hint of recognition a few months ago, when policymakers lowered the rate paid on reserves below what banks can get from low-risk lending elsewhere, but mostly policymakers have tried to get around the problem by bypassing the banks and injecting liquidity directly into financial markets. But buying government and corporate bonds on the open market, or quantitative easing, has also failed. Rather than reaching “Main Street,” where this torrent of money could have stimulated economic activity, the liquidity that the Fed has added to financial markets has merely bid up the prices of financial assets, quite apart from what was happening in the general economy.
An exceedingly cautious regulatory climate—a result of lessons learned in the 2008 financial crisis—has also blocked the flow of credit to the real economy. The Dodd-Frank financial reform, for example, penalizes banks that lend to business, especially small businesses. Because such lending carries greater risk than, say, buying government securities or simply leaving funds idle in Fed deposits, the law insists that banks set aside more capital than they otherwise would, denying them the high returns they would get from 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, which weakens their stock price. Though policymakers must see the effect, Congress seems to prefer playing it safe instead of allowing banks to take the risk of financing economic growth.
The Fed’s preference for using near-zero interest rates to stimulate economic activity has also had a perverse effect. In theory, reducing to nothing the cost banks incur from collecting deposits will encourage them to lend more freely and at more attractive rates to individuals looking to make big-ticket purchases, or to businesses that want to expand. In practice, however, the policy has made it especially attractive for banks to buy government bonds instead of making these economically important loans.
For instance, only two years ago, banks paid an average of about 1.3 percent to gather deposits, while earning 2.25 percent on a five-year Treasury note—a spread that allowed them to earn a 73 percent return, risk-free. Today, banks pay on average 0.09 percent on customer deposits and get a 0.32 percent return from a five-year Treasury note: a 156 percent return. The numbers are even better for ten-year bonds. No wonder the banks prefer lending to the Treasury over lending to small businesses. They earn an outrageous premium over cost, 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 U.S. 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, the biggest share since record-keeping started in 1985. At the same time, a survey conducted regularly by the Fed indicates that banks have significantly tightened their standards for lending to small businesses and individuals.
Because the Fed has failed to clean up this mess, it has also failed to achieve anything close to the stated aim of stimulating economic growth. Before monetary policymakers dramatically announce yet another tidal wave of money, they should find a way to fix these self-defeating policies.