Between 2008 and 2014, the Federal Reserve engaged in a series of asset purchases known as quantitative easing, or QE. The Federal Reserve’s QE efforts, which significantly expanded the monetary base, sought to stabilize the financial sector. QE 1 and QE 3 in particular included purchases of mortgage-backed securities and were intended to stabilize the real estate market in particular. QE has also had the consequence of increasing support for borrowing by the federal government.
The strategy appears to have been successful in preventing a major financial crisis over the last decade. The solution is not without its difficulties as the Federal Reserve has only slowly reduced the size of its balance sheet and indicated that it plans to cease doing so.
Inflation, Seigniorage, and Interest on Excess Reserves
Although the monetary base expanded by a factor of five between 2008 and 2014, the inflation rate has remained around 2 percent. The payment of interest on excess reserves, an integral part of the new monetary regime, has prevented the new base money from entering circulation. As Scott Sumner identifies, “The Fed has controlled inflation by adjusting both the supply and the demand for base money, but mostly demand” (emphasis mine). Money placed at the Federal Reserve would otherwise support the creation of new credit. The creation of new credit money would represent an increase in the velocity of the base and would lead to inflation.
The story, however, does not end here. The new system has created a source of seigniorage for three categories of actors: banks holding excess reserves, owners of real estate, and the federal government.
The most obvious provision of seigniorage is paid directly to banks that hold excess reserves. When the Federal Reserve increased the quantity of base money, it created new money in order to purchase mortgage-backed securities and U.S. Treasuries. Banks that sold these securities to the Federal Reserve would normally lend this new money to borrowers in the market. The new option made available by the Federal Reserve allows these banks to instead earn a risk-free rate of return.
It would not be incorrect to imagine the Federal Reserve printing money and simply handing it to these banks in exchange for their agreeing not to lend the new money. After the recent 25-basis-point cut in the federal funds rate, excess reserves earn 1.8 percent in interest. According to the most recent data provided by FRED, the value of excess reserves totals $1.34 trillion. At this rate, the Federal Reserve can expect to pay more than $24 billion, 0.12 percent of GDP, to banks that hold excess reserves on account. This is also equal to around 1.4 percent of the base money stock not removed from circulation.
The increase in the Federal Reserve’s balance sheet has supported increased demand for U.S. Treasuries and mortgage-backed securities. The Federal Reserve’s holdings of these types of debt necessarily depresses interest rates in these markets, thereby promoting more borrowing in them than would occur otherwise.
One way to gauge the value of seigniorage is to quantify the savings that accompanies a given level of debt for each 100-basis-point reduction in interest rates. The federal debt currently stands at $22 trillion. Each year federal spending exceeds revenues by more than $2 trillion. With just this value alone, the government implicitly receives more than $26 billion in seigniorage. Of government debt outstanding, $9.23 trillion will mature and need to be renewed within the next four years. Presuming the current regime continues for the next four years, for each 100-basis-point drop in interest rates, the government will receive annual seigniorage of at least $92 billion per year, not including future savings resulting from the compounding of interest payments that would occur otherwise. Repayment of securities held by the Federal Reserve represents self-remuneration. Any savings is moot as its profits are returned to the U.S. Treasury anyway.
At the start of 2019, the Federal Reserve was holding over 10 percent of U.S. home mortgages. At its peak, its holdings amounted to 12 percent of the market. The total value of this market is of magnitude comparable to the federal debt: $15.53 trillion. As with U.S. Treasuries, the length of life of a mortgage tends to be rather long — anywhere between 15 and 40 years — which makes calculation of seigniorage contributions to this group difficult without data reflecting the term of the loan, its date of origination, and value of loans refinanced each year.
Back-of-the-envelope calculations do provide some guidance. Taken as a whole, every 100-basis-point reduction in this market amounts to $155.3 billion. More than likely, not all loans have been impacted. Even if only 10 percent of the value in the market was subject to the reduction, a fall of 100 basis points would amount to mortgage holders receiving an annual subsidy of about $15 billion. The total value of the market subject to this reduction is certainly greater than 10 percent as more than a decade has passed since the initiation of the new monetary regime.
The estimates presented of the impact of this policy are, admittedly, back-of-the-envelope calculations. A series of regressions that estimate the marginal effects on interest rates of a change in holdings by the Federal Reserve would provide more accurate results.
Policy makers are able to hide the effects of their intervention since the new money is sterilized by payment of interest on excess reserves. The resulting redistribution of wealth is not insignificant, even if it is not easy to surmise. The mix of investing that we currently see is the result of distortions by the Federal Reserve.
Cantillon effects could normally be partly offset by firms that raise prices in light of inflation expectations, but even this option is unavailable as a result of the Federal Reserve’s sterilizing excess reserves. Second-order effects from this expansion likely spread this across financial markets, leading to more investment than would occur otherwise and may, for example, bear some responsibility for the current level of investment in equities.
President Trump has reason to be quite vocal about Jerome Powell’s historical unwillingness to ease monetary policy substantially. Reducing the balance sheet reverses the redistributive effects of this program and could limit the continual ballooning of federal expenditures.
The greater the unwinding of the balance sheet, the greater will be the difficulty of servicing federal debt. This problem is on the horizon. It will be met by a combination of dollar devaluation, reduction of the budget, or default.