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Why the Fed is paying Wall Street banks billions of dollars

(Reuters/Lucas Jackson)

Did you know that the Federal Reserve is paying banks billions of dollars not to lend money out?

Well, it is. But it is not actually a scandal. It is just how the Fed is trying to keep inflation in check now that it has printed so much money. Not that that should keep some politicians from trying to score whatever political points they can over this. Indeed, Senator Ted Cruz, the Republican presidential candidate, might already be.

Before we get to that, though, let's talk about what exactly the Fed is doing. The short answer is that it's raising rates. But the slightly longer one is that it's raising rates in a different way than it has before. Why? Well, when we talk about the Fed increasing interest rates, we're really talking about it increasing the interest rate that banks charge each other to borrow money from each other—money stored at the Fed as reserves. And the interest rate they charge depends on how many reserves they have. Think about it like this. The fewer reserves there are, the more valuable they become, and the more banks will ask for in return for them. So when the Fed has raised rates in the past, it's done so by selling bank short-term bonds that they have had to pay for out of their reserves, draining the financial system of them.

But that doesn't work quite as well when interest rates are zero. That's because, for the first time in 80 years, banks have more reserves than they are legally required to hold. A lot more—$2.5 trillion, to be exact. And that makes sense if you think about it. The fact that interest rates are zero means that banks are so stuffed with reserves that they are willing to lend them out for, well, nothing. And then some. The Fed, you see, tried to stimulate the economy even after interest rates fell to zero by buying long-term bonds from the banks with newly-printed money—which ended up as just more reserves.

Now, you might be wondering why the banks are just sitting on these trillions of dollars. After all, it's hard to make money lending it out if you aren't actually, you know, lending it out. The simple story is that, in the aftermath of the crisis, banks only want to lend to the most creditworthy people, but the most creditworthy people don't want to borrow that much. On top of that, though, the Fed has started paying banks a very modest amount—0.25 percentage points—on their reserves. That in itself isn't enough to convince the banks not to lend, especially if they saw opportunities they liked, but it is effectively paying them to do a little less of it.

The reason it's doing so is that it's the best way to increase interest rates right now. The easiest way to think about this is to remember that the Fed has been using two tools to try to revive the economy. The first is cutting interest rates and the second is all the bonds it has bought. Notice that I didn't say how many bonds it is currently buying, but rather how many it has bought in total. Long-term interest rates depend on the supply and demand of long-term bonds, so all the ones the Fed has bought in the past—effectively taking them out of circulation—help push down borrowing costs today. The problem, then, is that the Fed couldn't raise rates the way it always has without selling its trillions of bonds first. That would be the only way to suck up the trillions of dollars worth of reserves the banks have, which, in turn, would send interest rates dramatically up. The Fed, in other words, would have to undo its bond-buying stimulus at the same time that it undoes some of its rate-cutting stimulus.

And it doesn't want to do that. The economy probably couldn't handle that all at once. So the Fed is paying banks more interest on their reserves instead. The idea is that banks won't lend those reserves out for less than they can get for them from the Fed—and, as a result, interest rates on the former will go up if the one on the latter does first. Paying the banks $13 billion not to lend might seem, well, unseemly, but it's the only way to raise rates without completely pulling the rug out from under the economy.

It doesn't take a lot of imagination to see how paying bailed-out banks billions of dollars not to lend might become a political liability for the Fed. In fact, Cruz just made a point of asking Fed Chair Janet Yellen how much exactly the Fed has paid out and "what has the impact been of paying billions of dollars to those banks in those last seven years." Nobody has been threatening Yellen like they did Bernanke—remember when Rick Perry called him borderline "treasonous"?—but the Fed is still enough of a bête noire on the Republican side that it wouldn't be surprising for this to turn into a campaign issue.

But, again, it shouldn't. It's not just that this is the best way for the Fed to do its job. It's that it it ignores that the Fed has assets that should more than make up for its liabilities. The Fed, after all, has been in the extremely profitable business of buying things with the free money it has printed. Although it's not quite right to call that money "free." Sure, the Fed can create it out of thin air—or, more accurately, a computer keyboard—but it has to make sure that that doesn't turn into too much inflation. A few years ago, when that wasn't a concern, that meant the Fed was making  $80 or $90 billion for the government. But now that it is one, that might go down to $20 or $30 billion. So it's been keeping inflation low, bringing unemployment down, and the deficit too.

Not a bad deal.