Source: Bloomberg Business

A tool Congress gave the Federal Reserve to control interest rates has become a hammer for lawmakers to bash the central bank.

Fed Chair Janet Yellen withstood bipartisan criticism at a congressional hearing on Wednesday over the policy of paying the largest financial institutions to keep more funds than required on deposit at the central bank. The Fed doled out $1.7 billion in interest on excess reserves -- known as IOER for short -- to banks in the third quarter.

Congress, which gave the Fed authority in 2008 to pay interest on excess reserves, may be having second thoughts. While the tool helps the Fed raise its benchmark interest rate and simultaneously maintain a $4.5 trillion balance sheet that policy makers say supports the economy, several lawmakers complained to Yellen that IOER is enriching Wall Street.

California Representative Maxine Waters, the ranking Democrat on the House Financial Services Committee, labeled the IOER payments a “massive transfer of wealth from the Federal Reserve to private-sector banks.” Committee Chairman Jeb Hensarling, a Texas Republican, called it a “subsidy.”

In a election year, Yellen was grilled on campaign issues ranging from income inequality to high rates of minority unemployment. Candidates such as Senator Bernie Sanders, a socialist from Vermont who won the New Hampshire Democratic primary Tuesday, are finding that Wall Street-bashing resonates with voters struggling with slow wage increases.

The Center for Popular Democracy, part of a coalition known as Fed Up, said it met with Waters in September and discussed why paying banks interest on excess reserves is troublesome.

‘Anti-Consumer’

“It was a tool that was given to the Fed without ever envisioning an environment of multi-trillion dollar excess reserves,” said Jordan Haedtler, campaign manager for the group. “It’s a pretty crude, anti-consumer tool that rewards big banks.”  

Yellen defended the tool, noting that the flip side of the excess reserves are the Fed’s large asset holdings, which generated many more billions of dollars in remittances to the Treasury. She also warned that extinguishing reserves through asset sales could cause more volatility in financial markets and hurt growth.

“The Federal Reserve has transferred, since 2008 through 2015, roughly $615 billion back to Congress, to the taxpayers, to the Treasury, funds that have contributed importantly to financing the government,” Yellen said.

The Fed created hundreds of billions of excess reserves in the financial crisis as it began to rescue financial institutions such as Bear Stearns Cos. and conduct quantitative easing through direct bond purchases.

Normally, banks would try to dump some of the $2.3 trillion in excess reserves they now hold into overnight lending markets to try earning a return. That would swamp attempts by the Fed to control the federal funds rate and make raising rates difficult.

Bullard’s Warning

By paying a rate above its target rate for federal funds, the Fed can keep those funds out of the market and exert more control over its policy rate. To mop up other excess cash coming from sources other than commercial banks, the Fed uses another tool called reverse repurchase agreements where it uses securities as collateral for short-term loans of cash, thus removing it from the money markets.

The political liability of paying large sums of interest to private banks hasn’t been lost on Fed officials. St. Louis Fed President James Bullard said in August that the strategy would benefit from bipartisan support.

“It’s going to mean fairly large payments to the largest banks in the U.S. and to some foreign banks,” Bullard said in an August interview with Wharton Business Radio’s ”Behind the Markets” program on Sirius XM Radio. “If Congress is not comfortable with that, they should definitely tell us right now.”

Addressing Yellen during the hearing, Waters said, "It looks like we’re about to have some bipartisan concern on this issue."

The Fed chief responded, "I hear that."