Macro Update: Ceasing Interest Payments on Reserve Balances in a Fiscal Dominance Regime

Unpacking Seigniorage Dynamics and Fiscal Dominance

In the realm of a fiat currency system, a nation such as the United States holds the power to generate money to fund its expenditures, a practice often referred to as seigniorage. While the reins of budget control are held by the administration and Congress, collectively constituting the fiscal authority, the Fed assumes the role of overseeing seigniorage. This entails the creation of currency in circulation and the management of reserve balances held by banks within the Federal Reserve system. Notably, the seigniorage profits generated by the Fed are funneled into the Treasury's coffers, forming a crucial component of the fiscal authority's revenue.

A seminal work dating back to 1981, "Some Unpleasant Monetarist Arithmetic" penned by Sargent and Wallace, underlines the intrinsic interplay between monetary and fiscal policies, underscoring the necessity for their coordination. In fact, Section 2A of the Federal Reserve Act of 1913, a pivotal legal document, mandates the Fed not only to foster maximum employment and stable prices but also to ensure "moderate long-term interest rates." In essence, the Fed is tasked with facilitating the fiscal authority's ability to finance its budget shortfalls at levels of interest deemed to make debt servicing sustainable. Yet, this alignment between objectives, particularly stable prices and combatting inflation, may sometimes clash with the imperative to channel a continuous stream of seigniorage revenue to the fiscal authority, thus aiding its debt management and deficit financing endeavors.

The intricate balancing act between generating seigniorage revenue through monetary creation and mitigating the specter of inflation has led to a concept known as fiscal dominance. This term is employed when the pursuit of seigniorage revenue reaches a juncture where it constrains the Fed's capacity to effectively counter inflation. In such a scenario, the central bank finds itself in the intricate position of navigating between maintaining price stability and meeting the fiscal authority's needs, often prompting intricate policy decisions and adaptations.

In essence, the interaction between fiscal and monetary policies is an intricate dance that holds profound implications for economic equilibrium. The practice of seigniorage, as overseen by the Fed, plays a crucial role in funding government initiatives, yet its intersection with inflation-fighting efforts highlights the nuanced challenges in maintaining fiscal and economic stability. This intricate interplay forms the backdrop against which proposals to cease interest payments on reserve balances and elevate reserve requirement ratios must be carefully examined, as they have the potential to reshape the very foundation of monetary policy in the pursuit of fiscal goals.

Balancing Act: Navigating Monetary Policies and Fiscal Priorities

The current economic landscape of the United States is characterized by a public debt of approximately USD 25.71 trillion, accompanied by a net interest payment of around USD 640 billion estimated for 2023. This scenario implies an average interest rate of 2.5%. Additionally, the Fed holds USD 2.34 trillion in currency circulation, a reservoir that does not offer any interest to its holders. This status quo is akin to seigniorage revenue initially and an inflation tax in subsequent years, as those possessing the currency in circulation do not receive compensation for the loss of purchasing power spurred by inflation.

Moreover, the Fed has generated USD 3.27 trillion in reserve balances. Since October 2008, a pivotal shift has occurred in the realm of monetary policy, wherein the Fed initiated interest payments on both required reserve balances and excess reserve balances held by banks within its realm. This strategic move aimed to anchor the policy Fed Fund Rate. Additionally, the reserve requirement ratio was slashed to zero percent in March 2020, effectively nullifying minimum reserve requirment for banks. This initiative was geared towards implementing an "ample reserve" regime. Currently, the Fed extends a 5.4% annual interest rate on these reserve balances (IORB), leading to an annual expenditure of USD 177 billion. This stance diverges from the traditional trajectory of channeling a stream of seigniorage revenue to the Treasury, thereby damaging the Fed's role as a revenue-generating endeavor for the government. This paradigm shift transforms reserve balances at the Fed into economic equivalents of federal debts issued by the Treasury.

Reflecting on historical precedents, it becomes evident that when banks were mandated to maintain reserves at the Fed with zero interest, an implicit inflation tax was imposed upon them. However, the introduction of interest payments on reserve balances has effectively eradicated this inflation tax, signaling a noteworthy evolution in monetary policy. This evolution has blurred the lines between the creation of reserves by the Fed and the issuance of Treasury securities by the fiscal authority. In essence, the fiscal implications of these actions converge, as the profits and losses experienced by the Fed are ultimately funneled into the Treasury's coffers. For banks, the distinction between investing in Treasury securities and leaving money within the confines of the Fed becomes more subtle.

Federal Reserve's ON RRP Strategy: Anchoring the Target Fed Fund Range

Section 201 of the Financial Services Regulatory Relief Act of 2006 restricted the Federal Reserve's authority to pay interest solely on balances held by depository institutions. Consequently, non-bank entities, such as prominent US Government-sponsored Enterprises like Ginnie Mae, Fannie Mae, and Freddie Mac, as well as Federal Home Loan Banks and money market funds, were excluded from this provision. To prevent these institutions from lending funds at rates falling below the targeted range of the policy Fed Fund, the Fed introduced a Temporary Open Market Operations scheme. This initiative facilitated overnight reserve repurchase agreements (ON RRPs), colloquially referred to as overnight reverse repos, wherein non-bank entities could invest their funds.

Presently, the ON RRP rate is at 5.30%. By combining this rate with the interest rate on reserve balances (IORB) set at 5.4%, a band is established. This band tends to keep the effective Fed Fund rate oscillating between 5.40% and 5.30%, a range meticulously tailored to align with the Fed's desired Fed fund range of 5.25% to 5.50%. This intricate interplay between interest rates on reserve balances and overnight reverse repos underscores the Fed's efforts to fine-tune its monetary policy, ensuring economic stability within its target range but it has a huge cost in the form of interest payments.

Implications of Shifting Fiscal Dominance on Banking Profitability

As the fiscal burden continues to mount, the specter of a shifting balance towards fiscal dominance looms larger. Should monetary policy lean towards accommodating fiscal endeavors, akin to a fiscal dominance regime, the likelihood of the Fed reevaluating its existing policy of zero reserve requirement ratios and interest payments on reserve balances becomes more probable.

Should the Fed proceed with maintaining a zero reserve requirement while discontinuing interest payments on reserves, a cascade of consequences could unfold. Banks may be compelled to withdraw a substantial portion, if not the entirety, of their reserve balances held with the Fed. This exodus could entail a redirection towards investing in Treasury securities and other financial instruments that promise interest-bearing returns. Consequently, Treasury securities would become an attractive option and potentially facing an increase in demand and enjoying lower issuing costs. Nonetheless, they are interest-bearing and continue to incur financing costs to the fiscal authority. 

In order to replenish the stream of seigniorage revenue destined for the fiscal authority, the Fed might contemplate a strategic elevation of the reserve requirement ratio from zero to a considerably higher threshold. Recent upheavals in the US regional banking sector, notably triggered by the Silicon Valley Bank's collapse, could serve as a catalyst for political momentum in this direction. The Fed may also terminate the Temporary Open Market Operations since without paying interest on bank reserve balances, banks may simply move their reserve balances to invest in the ON RRP on that the Fed still pays interest. Without a band established by the 5.4% interest on reserve balances and the 5.3% interest on the ON RRP as an anchor, the resultant volatility in effective Fed Fund rates might eclipse their current stability, necessitating a potential return to daily open market operations conducted by the New York Fed on behalf of the Fed.

It's imperative to recognize that the imposition of non-zero required reserve ratios coupled with the cessation of interest payments on reserve balances would effectively translate into a tax on banks, thereby chipping away at their profitability. The magnitude of this tax burden would likely amplify should the Fed simultaneously exhibit tolerance for higher long-term inflation rates.

ECB's Shift: Interest Rate on Minimum Reserves Hits Zero, Impacting Monetary Landscape

A significant development occurred recently in the Eurozone as the European Central Bank (ECB) eliminated the interest rate applied to minimum (required) reserves, reducing it from the Deposit Facility Rate of 3.75% to zero percent. This decision reflects the ECB's strategic adjustment in its approach to managing inflation, as ceasing interest payments on mandatory minimum reserves aims to streamline monetary policy implementation.

Gathering at the upcoming Fed's Jackson Hole Monetary Policy Symposium this week are central bankers and renowned monetary economists. Notable figures like Fed Chair Powell, ECB President Lagarde, and BOE Deputy Governor Broadbent are set to present their perspectives. The symposium, themed "Structural Shifts in the Global Economy," will address various critical topics. While the full agenda release is scheduled for Thursday, August 24th, at 8 pm New York time, market observers anticipate discussions on deglobalization, shifts in long-term inflation rates, the non-accelerating inflation rate of unemployment (NAIRU), and fiscal deficits.

Given the global trajectory leaning towards a potential fiscal dominance regime, it's likely that conversations will emerge surrounding the retrieval of seigniorage revenue and the potential imposition of an inflation tax on the banking system. While these dialogues may not occur formally, they are expected to resonate as a significant undercurrent during the symposium's proceedings.

Navigating Economic Complexity: Unraveling Fiscal Dominance and Monetary Dynamics

In the intricate world of modern economics, the confluence of factors such as national debt, seigniorage, interest rates, and monetary policy intricacies is shaping the course of nations' financial futures. The delicate dance between fiscal dominance and the pursuit of economic stability challenges central banks and policymakers to strike a balance that safeguards both fiscal imperatives and the broader economic equilibrium. As discussions unfold at events like the Jackson Hole Monetary Policy Symposium, global leaders and monetary experts are poised to delve into these complex dynamics, seeking to decipher the paths forward. In a world increasingly characterized by shifts and uncertainties, the intricacies illuminated herein underscore the pressing need for nuanced strategies that fortify economic foundations while navigating the evolving currents of fiscal and monetary interplay.