Will Paying Interest on Reserves Endanger the Fed’s Independence?

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The U.S. Federal Reserve began a new policy of paying interest on excess bank reserves (IOER) during the Great Recession in 2008. In doing so, it set an effective floor to the federal funds rate, which allowed the Fed to all but dictate short-term open market interest rates. Both the Fed’s IOER policy and its subsequent rounds of large-scale asset purchases (also known as “quantitative easing,” or QE) have since become the primary monetary policy tools by which our central bank implements its policy decisions and in turn regulates the economy’s money supply.

Congress has subsequently used the Fed’s QE surplus to create and fund entire government programs and agencies. This has greatly increased the extent to which fiscal and monetary policy — and therefore congressional and central bank decisionmaking — rely on one another. The unprecedented interrelationship between monetary and fiscal policy holds alarming implications for the degree to which congressional whims can influence our central bank. As long as the Fed’s actions continue to affect important fiscal variables — such as the size of the federal deficit — the danger persists that politicians will attempt to dictate monetary policy, thereby endangering the Fed’s independence.

H. Robert Heller