Since 2008, the Fed has increased its holdings of Treasuries and mortgaged backed securities from less than $1 trillion to over $4 trillion due primarily to "quantitative easing" or QE. These securities have earned the Fed a considerable amount of interest, which is remitted to the Treasury at the end of the year, but what will happen to these earnings if the Fed starts raising rates? To answer this question we need to research what has become the most important rate in the world -- and it's not the fed funds rate.
Ben Bernake started saying that the interest rate on excess reserves (IoER) would be the primary way the FOMC would control the fed funds rate in 2013. This was reiterated in the minutes to the last FOMC meeting by Yellen. In fact, it is stated on the Fed's website and was formally introduced into policy on September 16-17 at the FOMC policy meeting in 2014. Here's an excerpt from that announcement:
During normalization, the Federal Reserve intends to move the federal funds rate into the target range set by the FOMC primarily by adjusting the interest rate it pays on excess reserve balances.
Since the Fed's kept rates low for a long time, any rate increase will be driven, for the first time in monetary history, by the IoER. So what exactly is the IoER?
The IoER is just a component of the interest rate paid on reserves. Reserves are set at 10% of loans so anything over 10% is considered excess. In exchange for holding reserves the bank meets regulatory requirements and can also participate in the fed funds market, or the interbank lending market.
Federal Reserve Banks have been paying interest on reserves since the crisis began in October 2008. The Bank of England started paying interest on reserves in 2009, and the European Central Bank has had this authority from its inception in 1999. So, what prompted this change in policy for the U.S.?
In 2006, before the crisis began, Congress passed the Financial Services Regulatory Relief Act of 2006. It authorized the Fed to pay interest on reserves and was meant to go into effect on October 1, 2011. However, once the financial crisis hit, the date was moved up three years through the Emergency Economic Stabilization Act of 2008.
When the IoR was first implemented the FRB set the interest rate paid on required reserves above the rate paid on excess reserve balances. Since January 2009, however, the rate has been .25% in order to maintain the fed funds target range of 0 to 25 basis points.
Excess Federal Reserve Bank earnings are paid to the federal government through the Treasury and were about $99 billion in 2014, up from $77 billion in 2013, and $88 billion in 2012. According to Fed projections, all that's about to change with an increase in the IoER.
The amount of excess reserves is around $3.2 trillion, according to Fed Vice Chairman Stanley Fischer's speech at the 2015 U.S. Monetary Policy Forum. That means the Fed is paying over ~$6 billion in interest on excess reserves this year, almost double the amount paid last year, which reduces the amount the Fed remits to the U.S. Treasury.
According to the FRB, "The projections imply that Federal Reserve remittances to the Treasury may decline for a time, and in some cases fall to zero."
What exactly does all this mean? It means that higher interest rates, all other things equal, result in lower earnings for the Fed, and higher earnings for banks. Here's an excerpt from the announcement:
With higher interest rates, earnings tend to fall a bit more and remittances to the Treasury stop for a longer period than in our baseline projections, while with lower interest rates earnings are a bit larger and remittances continue throughout the projection period.
In other words, as the FOMC raises fed funds guidance by raising the IoER, the Fed will be earning less and remitting less to the Treasury. There appears to be little debate over this scenario. That said, the jury is still out on whether or not raising the IoER will be an effective tool for controlling the fed funds rate. Some say it will while others believe it's just another example of regulatory capture; that is, bankers looking out for bankers at the expense of the economy. Only time will tell. One thing's certain, the IoER is the new Belle of the Ball.
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