    [House Hearing, 114 Congress]
    [From the U.S. Government Publishing Office]

                            INTEREST ON RESERVES AND
                            THE FED'S BALANCE SHEET

    =======================================================================

                                    HEARING

                                   BEFORE THE

                            SUBCOMMITTEE ON MONETARY

                                POLICY AND TRADE

                                     OF THE

                        COMMITTEE ON FINANCIAL SERVICES

                         U.S. HOUSE OF REPRESENTATIVES

                        ONE HUNDRED FOURTEENTH CONGRESS

                                 SECOND SESSION

                                   __________

                                  MAY 17, 2016

                                   __________

           Printed for the use of the Committee on Financial Services

                               Serial No. 114-87

                [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

                                   _________

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                     HOUSE COMMITTEE ON FINANCIAL SERVICES

                        JEB HENSARLING, Texas, Chairman

    PATRICK T. McHENRY, North Carolina,  MAXINE WATERS, California, Ranking
        Vice Chairman                        Member
    PETER T. KING, New York              CAROLYN B. MALONEY, New York
    EDWARD R. ROYCE, California          NYDIA M. VELAZQUEZ, New York
    FRANK D. LUCAS, Oklahoma             BRAD SHERMAN, California
    SCOTT GARRETT, New Jersey            GREGORY W. MEEKS, New York
    RANDY NEUGEBAUER, Texas              MICHAEL E. CAPUANO, Massachusetts
    STEVAN PEARCE, New Mexico            RUBEN HINOJOSA, Texas
    BILL POSEY, Florida                  WM. LACY CLAY, Missouri
    MICHAEL G. FITZPATRICK,              STEPHEN F. LYNCH, Massachusetts
        Pennsylvania                     DAVID SCOTT, Georgia
    LYNN A. WESTMORELAND, Georgia        AL GREEN, Texas
    BLAINE LUETKEMEYER, Missouri         EMANUEL CLEAVER, Missouri
    BILL HUIZENGA, Michigan              GWEN MOORE, Wisconsin
    SEAN P. DUFFY, Wisconsin             KEITH ELLISON, Minnesota
    ROBERT HURT, Virginia                ED PERLMUTTER, Colorado
    STEVE STIVERS, Ohio                  JAMES A. HIMES, Connecticut
    STEPHEN LEE FINCHER, Tennessee       JOHN C. CARNEY, Jr., Delaware
    MARLIN A. STUTZMAN, Indiana          TERRI A. SEWELL, Alabama
    MICK MULVANEY, South Carolina        BILL FOSTER, Illinois
    RANDY HULTGREN, Illinois             DANIEL T. KILDEE, Michigan
    DENNIS A. ROSS, Florida              PATRICK MURPHY, Florida
    ROBERT PITTENGER, North Carolina     JOHN K. DELANEY, Maryland
    ANN WAGNER, Missouri                 KYRSTEN SINEMA, Arizona
    ANDY BARR, Kentucky                  JOYCE BEATTY, Ohio
    KEITH J. ROTHFUS, Pennsylvania       DENNY HECK, Washington
    LUKE MESSER, Indiana                 JUAN VARGAS, California
    DAVID SCHWEIKERT, Arizona
    FRANK GUINTA, New Hampshire
    SCOTT TIPTON, Colorado
    ROGER WILLIAMS, Texas
    BRUCE POLIQUIN, Maine
    MIA LOVE, Utah
    FRENCH HILL, Arkansas
    TOM EMMER, Minnesota

                         Shannon McGahn, Staff Director
                        James H. Clinger, Chief Counsel
                   Subcommittee on Monetary Policy and Trade

                       BILL HUIZENGA, Michigan, Chairman

    MICK MULVANEY, South Carolina, Vice  GWEN MOORE, Wisconsin, Ranking
        Chairman                             Member
    FRANK D. LUCAS, Oklahoma             BILL FOSTER, Illinois
    STEVAN PEARCE, New Mexico            ED PERLMUTTER, Colorado
    LYNN A. WESTMORELAND, Georgia        JAMES A. HIMES, Connecticut
    MARLIN A. STUTZMAN, Indiana          JOHN C. CARNEY, Jr., Delaware
    ROBERT PITTENGER, North Carolina     TERRI A. SEWELL, Alabama
    LUKE MESSER, Indiana                 PATRICK MURPHY, Florida
    DAVID SCHWEIKERT, Arizona            DANIEL T. KILDEE, Michigan
    FRANK GUINTA, New Hampshire          DENNY HECK, Washington
    MIA LOVE, Utah
    TOM EMMER, Minnesota

                                C O N T E N T S

                                  ----------
                                                                       Page
    Hearing held on:
        May 17, 2016.................................................     1
    Appendix:
        May 17, 2016.................................................    41

                                   WITNESSES
                             Tuesday, May 17, 2016

    Eisenbeis, Robert A., Vice Chairman, Cumberland Advisors.........     5
    Keister, Todd, Professor of Economics, Rutgers University........     7
    Selgin, George, Director, Center for Monetary and Financial
      Alternatives, Cato Institute...................................     9
    Taylor, John B., Mary and Robert Raymond Professor of Economics
      at Stanford University.........................................    11

                                    APPENDIX

    Prepared statements:
        Waters, Hon. Maxine..........................................    42
        Eisenbeis, Robert A..........................................    47
        Keister, Todd................................................    59
        Selgin, George...............................................    67
        Taylor, John B...............................................    83

                  Additional Material Submitted for the Record

    Huizenga, Hon. Bill:
        Written statement of David Malpass...........................    90

                            INTEREST ON RESERVES AND

                            THE FED'S BALANCE SHEET

                                  ----------

                             Tuesday, May 17, 2016

                 U.S. House of Representatives,
                               Subcommittee on Monetary
                                      Policy and Trade,
                               Committee on Financial Services,
                                                       Washington, D.C.
        The subcommittee met, pursuant to notice, at 10:03 a.m., in
    room 2128, Rayburn House Office Building, Hon. Bill Huizenga
    [chairman of the subcommittee] presiding.
        Members present: Representatives Huizenga, Mulvaney,
    Pearce, Stutzman, Pittenger, Messer, Schweikert, Guinta, Love,
    Emmer; Moore, Foster, Himes, Murphy, Kildee, and Heck.
        Ex officio present: Representatives Hensarling and Waters.
        Chairman Huizenga. The Subcommittee on Monetary Policy and
    Trade will come to order. Without objection, the Chair is
    authorized to declare a recess of the subcommittee at any time.
        Today's hearing is entitled, ``Interest on Reserves and the
    Fed's Balance Sheet.''
        I now recognize myself for 5 minutes to give an opening
    statement.
        So how did the Fed receive authorization to pay interest on
    reserves? At what level was it supposed to have set that
    interest rate?
        And most importantly, how is this new and powerful tool for
    conducting monetary policy affecting our economy, which
    continues to disappoint after having 7 years to recover?
        We will hear some of the answers to these questions and
    many others during today's important hearing. And I feel I need
    to address something that came to my attention a little earlier
    this morning.
        Apparently, there are some folks on Wall Street who have
    sent out some alerts using that term themselves about this
    hearing, that somehow interest on reserves is under attack.
        To the fine folks up on Wall Street, you are on notice. We
    are going to have a thorough complete examination of what it
    is. I think there is a tremendous amount of questions that
    surround it.
        In fact, in February when Chair Yellen was here testifying
    in front of the full Financial Services Committee, there were a
    number of concerns expressed on both sides of the aisle.
        In fact, as I recall, Chairman Hensarling allowed the
    ranking member to go long, as she was asking a line of
    questioning about that. And so there are quite a few questions
    on both sides of the aisle about it.
        And as we are looking at foreign subsidiaries and large
    banks being the recipients of the lion's share of this, that
    has a number of people very concerned of how that may also
    affect our small community banks and our regional banks and the
    liquidity in the marketplace.
        So there are a tremendous number of questions that are out
    there, and we intend on this subcommittee to explore those.
        The Financial Services Regulatory Relief Act of 2006
    authorized the Federal Reserve Board to start paying interest
    on reserves in 2011.
        In response to the financial crisis, the Emergency Economic
    Stabilization Act accelerated this authority to October 1,
    2008. According to the New York District Bank, the Fed expected
    to set interest rates, interest on reserves well below the
    Fed's target policy rate, that is, the Federal Funds rate.
        Had the Fed created such a ``rate floor,'' it would have
    complied with the letter of the law, Section 201 of the
    Financial Services Regulatory Relief Act of 2006, which
    explicitly states that interest on reserves ``cannot exceed the
    general level of short-term interest rates.''
        As we sit here today, however, interest on reserves is
    above the Federal Funds rate. This above-market rate not only
    appears to have gone outside the bounds of the authorizing
    statute, it also may be discouraging the more free flow of
    credit to an economy that can and should be flourishing.
        Speeding up the authority to pay interest on reserves
    equips the Fed to expand its balance sheet to previously
    unimaginable heights and broaden its remit to, as University of
    California economist James Hamilton put it, ``the decision of
    where credit gets allocated.''
        Responding to the immediate financial crisis, the balance
    sheet more than doubled to almost $2 trillion. Subsequently,
    various rounds of quantitative easing saw the balance sheet
    more than double again.
        Today, the Fed's balance sheet stands at $4.5 trillion.
    That is about 25 percent of the total GDP of the United States.
    And as I say to folks back home, sometimes we lose perspective
    on how many zeros are in a trillion.
        And I always tell them, write a one and 12 zeros behind it
    and start counting backwards to where it is a thousand, ten
    thousand, a hundred thousand, and you see how big those numbers
    really are.
        At the same time, the average maturity of Treasury
    securities held by the Fed increased from about 5 years to over
    10 years, which considerably increases the balance sheet's
    exposure to interest rate duration risk.
        Almost 7 years old, the Fed's colossal and distortionary
    balance sheet shows no signs of shrinking. To be sure, the Fed
    appears to have only started thinking about an exit as
    described in its late 2014 Policy Normalization Principles and
    Plans report, but the word ``principles'' is nowhere to be
    found in this description.
        Moreover, the plan simply mimics the same opaque ``data-
    dependent strategy'' for monetary policy that has left market
    participants scratching their heads for years wondering what
    data will inform the Fed's decision-making and how will the
    FOMC react to that data.
        We will not fully realize robust economic growth until the
    Fed returns to a rules-based strategy for reliable supporting
    of the free flow of goods and services with an efficient
    exchange mechanism, in my opinion.
        As former Federal Reserve Board Governor Kevin Warsh
    observed, ``Currency stability is one of growth's best
    friends.'' Unfortunately, monetary policy has clearly stepped
    outside this bound and shows little, if any, sign of returning.
        This lack of a clear and prudent strategy not only puts
    present economic opportunity at risk, it threatens the
    durability of monetary policy independence itself.
        Today's hearing provides us with another opportunity to
    examine how the Federal Reserve conducts monetary policy and
    why the development of these policies is in desperate need of a
    more disciplined and transparent approach.
        Needless to say, the Fed's high degree of discretion and
    its lack of transparency in how it conducts monetary policy
    continue to suggest that reforms are needed.
        My time has expired. The Chair now recognizes the ranking
    member of the subcommittee, the gentlelady from Wisconsin, Ms.
    Moore, for 5 minutes for an opening statement.
        Ms. Moore. Thank you so much, Mr. Chairman. And I want to
    welcome the witnesses. I think everyone seems to agree that the
    current situation is our rational and predictable way for the
    Fed to raise interest rates, which is what they have done.
        And that is primarily to pay interest on excess reserves. I
    agree with it, but I certainly can understand why perhaps Dr.
    Taylor here and others may disagree with why or how the Fed got
    here.
        But for those who understand the Fed's use of the IOER and
    to a lesser extent, the reverse repo markets, this is the best
    way for increasing interest rates, because we have to return
    some sort of normalization.
        We just can't have close to zero interest rates. Congress
    voted to provide the Fed with the ability to pay interest on
    excess reserves in 2006 when it passed H.R. 3505, a bill
    sponsored by our Chairman Hensarling.
        Many of us voted for this bill, myself included. So we
    clearly and affirmatively authorized the Fed to take these
    actions. We know that this is not only a tool that our central
    bank, our Fed, used but that many other central banks are also
    currently employing.
        In other words, our Fed used the best tool for the job that
    is both well-established among central banks and authorized by
    our Congress. I do agree that it is horrible optics.
        It is a policy debate that is raging because there is a
    concern about subsidizing the banks. I do feel encouraged to
    know that the profits, whatever profits are received from the
    Fed actually go back to the Treasury.
        So, it is horrible optics, but I don't think in reality we
    are subsidizing the banks. This is a very complicated policy,
    so I definitely look forward to this hearing.
        And I know that is true for us in liberal Milwaukee, as
    well as conservative Michigan Heights, Michigan. I would like
    to yield the rest of my time to the ranking member of the full
    Financial Services Committee, Ms. Waters.
        Ms. Waters. Thank you very much, Congresswoman Moore, but I
    would like to yield my time to Mr. Himes.
        Ms. Moore. I will yield the time to Mr. Himes.
        Ms. Waters. Thank you.
        Mr. Himes. Thank you to the ranking member and to Ms. Moore
    for that. I am not entirely prepared for the time, but I do
    feel very strongly about this. And so thank you, I really
    appreciate the yielding of time.
        Look, the subjects don't get a lot more complicated than
    interest paid on excess reserves, but there are two things that
    are pretty uncomplicated. And those two things are why I am
    here.
        Number one, there is a certain irony to the Congress of the
    United States holding the Fed up for scrutiny for their conduct
    of monetary policies since the crisis of 2008.
        With the exception of the American Recovery Act, which was
    profoundly controversial and partisan here, Congress has
    utterly and completely abnegated its role to conduct the kind
    of fiscal policy that classical economics and most economists
    would say we should have done.
        Yes, we passed the Recovery Act and that was about $800
    billion of fiscal stimulus. Most economists today, those who
    are driven by empirical analysis, would tell you that was too
    little and too heavy on tax cuts and not heavy enough on
    infrastructure investment and the kind of things that actually
    put Americans back to work.
        Okay, so we had that fiscal stimulus. That was important.
    Since then, since 2009, the Congress has completely abdicated
    the role that economists across the political spectrum would
    say we should do, which is to continue with classic fiscal
    stimulus.
        So, in the context of the Congress completely abnegating
    its fiscal role, we have had no other game in town but for the
    monetary policy conducted by the Federal Reserve.
        And you know what, we highlight the word ``innovative''
    around here, and we say we want them to be innovative. Yes,
    their policies with the Twist and with QE2 were innovative.
        They were different than the conduct of monetary policy,
    but because of the Federal Reserve's policy, including the
    payment of interest on reserves we have what is without
    question the most robust recovery amongst industrialized OECD
    nations however you want to play it.
        And I have asked this question of Chairman Bernanke time
    and time again. Now this is a complicated thing, but we need to
    talk more about the fact that this is a transaction with two
    parts.
        Yes, we pay about $7 billion, or the Fed pays about $7
    billion. Meanwhile, the Fed is returning about $100 billion to
    the United States Treasury. Those are the two halves of this
    transaction.
        And I do hope we have an opportunity to discuss that in
    this hearing. I thank the ranking member for the time and I
    yield back.
        Chairman Huizenga. The gentlelady's time has expired. And I
    imagine we will get into a few of those issues today with the
    testimony of our panel of experts we welcome today.
        First, we have Dr. Robert Eisenbeis, vice chairman of
    Cumberland Advisors
        Second, we have Dr. Todd Keister, professor of economics at
    Rutgers University.
        Third, we have Dr. George Selgin, director of the Center
    for Monetary Policy and Financial Alternatives at the Cato
    Institute.
        And last, but certainly not least, we have Dr. John B.
    Taylor, the Mary and Robert Raymond professor of economics at
    Stanford University.
        Each of you will be recognized for 5 minutes to give an
    oral presentation of your testimony, which we have received
    written copies of previously, and without objection, each of
    your written statements will be made a part of the record.
        And before I forget, Dr. David Malpass was supposed to be
    part of this panel today. Unfortunately, he had a death in the
    family, and we wish him and his family all the best.
        They are in our thoughts and prayers collectively. I would
    like to submit for the record, without objection, his written
    testimony as well, and would ask that we make that a part of
    the record.
        With that, Dr. Eisenbeis, you are recognized for 5 minutes.

      STATEMENT OF ROBERT A. EISENBEIS, VICE CHAIRMAN, CUMBERLAND
                                ADVISORS

        Mr. Eisenbeis. Thank you very much. Chairman Huizenga, and
    Ranking Members Moore and Waters, I really appreciate the
    opportunity, and I am honored to be here today.
        I want to address in particular certain misconceptions
    about the Federal Reserve's balance sheet and some of the fund
    flows that take place between the Fed and the Treasury and how
    that interplays with the interest on reserves.
        Often the Fed is compared to a private sector bank, but
    there are really some fundamental differences between the Fed
    and a private sector bank.
        The Fed is a government entity and when analyzing payment
    flows and fund flows and balance sheets, I think it is really
    best to look at the process and implications from the
    perspective of the consolidated governments balance sheet
    rather than separately the Federal Reserve and the Treasury.
        Unlike a private bank, to purchase assets, the Fed really
    doesn't have to go into the marketplace and pay interest on
    funds in order to generate the resources to purchase government
    securities.
        When it purchases a security, essentially what it does is
    it increases the reserve account of the seller's bank's reserve
    account. And had it paid for Treasuries by drawing down its
    stock of Federal Reserve notes, we would have said the Fed had
    printed money and monetized Treasury debt.
        It is also important to understand that unlike deposits at
    a private sector bank, reserves never leave the Federal Reserve
    when one bank or one of its customers engages in a transaction.
    Ownership of a reserve account may change, but the funds never
    leave the Fed.
        Now what about payment of interest on reserves? The Fed is
    paid interest by the Treasury on its portfolio holdings. It
    then extracts its operating costs, including interest payments
    on reserves and returns the remainder to the Treasury.
        From the perspective of the consolidated Fed/Treasury/
    Government balance sheet, the Fed purchases higher cost
    Treasury debt off the market and replaces it with another form
    of de facto Government short-term debt paying 50 basis points.
        If this intragovernmental transfer of funds between the Fed
    and the Treasury were settled the way interest rates swaps are
    settled by netting, there would always be a net payment, a
    transfer of funds from the Treasury to the Fed.
        Furthermore, Treasury securities are effectively retired
    because of the fact that the government owns its own debt. The
    Treasury is covering the Feds operating costs and effectively
    is making those interest payments on reserves.
        So it is a mistake to characterize Fed remittances, as is
    commonly done, as a return of profits made by the Fed to the
    Treasury. It is only due to a flaw in government accounting
    that the Treasury can count such remittances from the Fed as
    revenue for budget purposes.
        This is clearly a case of questionable accounting, and is
    misleading when it comes to the treatment of government
    revenues and resources. Our interest payments are subsidied to
    banks. This is a common question and concern.
        In the wake of the Great Recession, interest on reserves
    became an essential tool for the Fed to influence short-term
    interest rates. For most of history, the Federal Reserve had
    paid no interest on reserves at all.
        But requiring banks to hold a portion of their assets as
    noninterest-bearing reserves against their deposits effectively
    reduced bank earnings and functioned like a tax.
        Because this tax was high and especially during inflation
    periods like we had in the 1970's and 1980's, many banks opted
    to give up their membership in the Federal Reserve.
        And the Fed even resorted to providing free payment
    services to the equivalent of toasters, we saw in the private
    sector, to offset the ongoing cost of membership.
        Predictably, banks sought to minimize excess reserves by
    expanding loans, thus converting excess reserves into required
    reserves. For the banking system as a whole, this practice
    created a money multiplier where $1 reserves could conceptually
    support even a tenfold increase in the money supply and
    potentially trigger an explosion in inflation.
        This unwelcome prospect explains why economists and some
    members of the FOC are and have been concerned about the need
    to wind down its portfolio and decrease the amount of excess
    reserves and return interest rates to normal.
        In this context, the Fed ability to pay interest on
    reserves is critical to keeping interest rates, the money
    supply, and inflation under control, consistent with the Fed's
    dual mandate.
        However, there is an additional issue when we recognize, as
    shown in Figure 1 attached to my written testimony, but a
    substantial portion of the excess reserves in the financial
    system are actually in the U.S. subsidiaries and affiliates of
    foreign banks, which now account for 40 percent of the excess
    reserves, but only about 10 percent of U.S. domestic deposits.
        Because of this imbalance, they also receive a
    disproportionate share of the interest payments on reserves
    relative to domestic institutions.
        There are really two explanations for this imbalance.
    First, the Dobbs Bank Act changed how deposit insurance
    assessments were charged. Large banks, mainly those over $500
    billion, now pay 15 basis points or more on total assets.
        This means that while they currently earn 50 basis points
    on their reserves, their net return is 35 basis points. It was
    10 basis points prior to the rate change in December of 2015.
        In contrast, foreign banks aren't subject to the 15 basis
    point assessment. They are able to earn the full 50 basis
    points on their excess reserves. But for foreign institutions
    headquartered in Europe or Japan, for example, where policy
    rates are now negative, the spread is even wider.
        In the case of European Bank it is now 90 basis points, and
    reserves at the Fed are clearly an attractive asset in earning
    asset.
        Chairman Huizenga. Dr. Eisenbeis, I have to interrupt. Time
    has expired at this point, and we will have to return back to
    you during questions.
        Mr. Eisenbeis. Fine.
        Chairman Huizenga. All right, I appreciate that.
        Mr. Eisenbeis. Thank you.
        [The prepared statement of Dr. Eisenbeis can be found on
    page 47 of the appendix.]
        Chairman Huizenga. Dr. Keister, you are recognized for a
    generous 5 minutes as well, so, and we thank you for that.

      STATEMENT OF TODD KEISTER, PROFESSOR OF ECONOMICS, RUTGERS
                               UNIVERSITY

        Mr. Keister. Thank you, Mr. Chairman, Ranking Member Moore,
    and members of the subcommittee. The ability to pay interest on
    reserves is an important policy tool, and Congress'
    authorization of these payments in 2006 was a welcome
    development. In the aftermath of the financial crisis, the Fed
    has come to rely more heavily on this tool than was previously
    anticipated.
        Because paying interest on reserves is still relatively new
    in the United States, there is naturally some uncertainty in
    the minds of both the public and policymakers about the
    implications of this tool.
        In my comments today, I will argue that continuing to pay
    interest on both required and excess reserves is not only
    essential for the implementation of monetary policy, but also
    sound economic policy.
        I will focus on four key points. First, paying interest on
    excess reserves has no cost to the taxpayer. To understand why,
    it is helpful to walk through the mechanics of how bank
    reserves are created using a simple example.
        Imagine we start with a situation in which I personally
    owned a U.S. Treasury Bond. And the U.S. Government regularly
    pays interest on that bond to me. Now suppose I decide to sell
    this bond and that the Fed purchases my bond.
        When this transaction takes place, the Fed credits my bank
    with reserves equal to the value of the bond, and my bank
    credits my account in the same amount. In this new situation,
    the Treasury pays interest on the bond to the Fed.
        The Fed pays interest on the reserves to my bank. And my
    bank pays interest on my deposit to me. In other words, the Fed
    paying interest on reserves is a link in a chain of payments
    that replaces payments the Treasury would otherwise be making
    directly to bondholders.
        Seen this way, the operation clearly creates no cost for
    the taxpayer. In fact, as we have already heard, since the
    interest rate on excess reserves is generally lower than the
    interest rate on long-term Treasury bonds, the operation
    creates a net gain for the taxpayer.
        My second point is that paying interest on excess reserves
    is not a subsidy to banks. Suppose I keep the money I receive
    from the sale of the bond in my savings account. Then my bank
    would be earning 50 basis points on the newly created reserves,
    but it would be paying me approximately 30 basis points on my
    new deposit.
        My deposit also increases the bank's cost indirectly by
    raising the deposit insurance fees it must pay to the FDIC and
    by increasing its leverage. Overall, the bank may make a small
    profit on this transaction, but to a first approximation it
    will roughly break even.
        So taking into account the cost as well as the benefits of
    my deposit to the bank shows that earning interest on excess
    reserves does not represent a subsidy.
        My third point is that policy should be designed to
    encourage banks to hold excess reserves. Bank reserves are the
    life blood of our Nation's payment system. Every business day,
    more than $3 trillion of payments are made over the Fed's
    network. Banks are making these payments on behalf of their
    customers using the reserves they hold on deposit at the Fed.
        Prior to 2008 when no interest was paid on reserves, the
    Fed needed to create a scarcity of reserves to keep market
    interest rates positive. In fact, reserves were so scarce that
    our payment system could not adequately function using those
    reserves alone. Instead the Fed permitted banks to run
    overdrafts in their reserve accounts for a few hours each day
    solely for the purpose of allowing the payment system to
    function.
        These overdrafts were large at times, with an average daily
    peak value of more than $180 billion in 2007. One byproduct of
    the large expansion of bank reserves that has occurred over the
    last few years is that these intraday overdrafts have fallen by
    more than 90 percent, decreasing the risk to the Fed and
    ultimately to the taxpayer.
        In addition, payments are on average being sent earlier in
    the day, eliminating bottlenecks, reducing delays, and
    enhancing the resilience of our payment system.
        This brings me to my final point. The Fed's balance sheet
    should remain larger than its pre-crisis level even in the long
    run. While the Fed's balance sheet should and will shrink
    substantially from its current level, it would be a mistake to
    return to the precrisis approach of creating a scarcity of bank
    reserves to control interest rates.
        There have been substantial changes in the financial system
    since 2008, including a greater awareness of liquidity risks,
    and new regulations that are increasing banks' demand for safe
    liquid assets, such as reserves.
        Going back to the old approach of controlling interest
    rates by creating a scarcity of reserves not only runs counter
    to the goals of these new regulations, but also would likely be
    less effective in achieving the desired level of market
    interest rates than in the past.
        In contrast, the Fed holding a moderately larger balance
    sheet and relying primarily on the interest rate on excess
    reserves to steer market rates would be a more effective way to
    implement monetary policy going forward, while simultaneously
    promoting safety and efficiency in the payment network that
    underlies our financial system.
        Thank you again for this opportunity to testify before you
    today. I would be happy to answer any questions.
        [The prepared statement of Dr. Keister can be found on page
    59 of the appendix.]
        Chairman Huizenga. Thank you, Dr. Keister.
        Dr. Selgin, you are recognized for 5 minutes.

     STATEMENT OF GEORGE SELGIN, DIRECTOR, CENTER FOR MONETARY AND
                 FINANCIAL ALTERNATIVES, CATO INSTITUTE

        Mr. Selgin. Mr. Chairman, Ranking Member Moore, and
    distinguished subcommittee members, the original intent of the
    2006 legislation granting the Fed permission to pay interest on
    reserves was to resolve what in retrospect was a rather minor
    inefficiency in the payment system related to the opportunity
    costs of holding non-interest earning reserves.
        The accelerated deployment of that authority in 2008 was
    undertaken as a contractionary monetary measure. This was its
    avowed purpose. At the time, the Federal Reserve believed that
    its emergency lending would create excessive credit in the
    system and prevent it from reaching its monetary policy
    targets.
        We know in retrospect that this decision was tragically
    mistaken. Because at the very time that the Fed began to
    encourage banks to hoard reserves rather than lend them, the
    economy's total spending was collapsing and it continued to
    collapse afterwards from what had been a growth rate of about 3
    percent at the beginning of 2007, to a rate of minus 3 percent
    at the end of 2008, beginning of 2009.
        The combination of interest on reserves, which is designed
    to prevent banks from lending either to each other or to the
    market in general, and massive reserve creation by the Federal
    Reserve resulted in a massive accumulation not just of
    reserves, but of excess reserves, that is reserves held without
    any corresponding increase in required reserves that would
    occur if deposits had also expanded. In fact, bank deposits did
    not increase despite a tremendous increase in total reserves in
    the system as they normally would.
        Banks before 2008 seldom held more than $1.8 billion in
    excess reserves. At some point after this policy was
    implemented, after the Federal Reserve also had engaged in its
    third round of quantitative easing, they held $2.7 trillion of
    excess reserves, and they still hold about $2.3 trillion.
        Normally banks shed their excess reserves by trading them
    for higher yielding assets or lending them to other banks. Even
    if they don't want to incur risk, they can trade their excess
    reserves for higher yielding safe Treasury securities.
        Interest on reserves eliminated the incentive for them to
    do that and to therefore contribute to a more general expansion
    of deposits and credit by making reserves earn more than
    Treasuries, as they have done for the most part ever since the
    policy was implemented.
        The result, to use some economics jargon, is that the
    normal money multiplier, which gives you the relationship
    between total bank reserves in the system and total money
    supply including bank deposits, collapsed.
        This caused quantitative easing to be much less effective
    in increasing spending, income, and employment than it would
    have been otherwise. Because almost all the new reserves
    created by the massive quantitative easing programs the Fed
    undertook simply piled up in banks and mainly, as Dr. Eisenbeis
    just explained, in foreign banks.
        The large expansion of the Fed's balance sheet that has
    gone along with this hoarding of bank reserves, and what I mean
    is that has been made the accumulation of excess reserves
    possible, has also involved, because banks have not increased
    credit proportionately, a tremendous increase in the Federal
    Reserve's share of financial intermediation from about 10
    percent of total allocation of credit in the economy, of money-
    based credit, to just about 30 percent.
        Ladies and gentlemen, central banks have never been
    intended to be efficient allocators of the Nation's scarce
    savings. And the Fed is no exception. It was an inefficient
    investor of savings before the crisis.
        Naturally, it was never intended to be looking for
    productive lending opportunities. The changes in its balance
    sheet since have made it a far more inefficient employer of
    savings. The inefficiency that results from the Feds having
    nationalized so many savings far exceeds those that the
    original Act allowing payment of interest on reserves was
    supposed to correct.
        Ladies and gentlemen, I have very little time, but I will
    simply say that contrary to what some of the other speakers
    have said, we desperately need to return to the old-fashioned
    way of conducting monetary policy by having the Fed unwind its
    balance sheet, get rid of the assets it has accumulated, allow
    banks to earn interest only on required reserves, and encourage
    them not to hold excess reserves but instead to engage in
    productive lending.
        I am going to yield the rest of my time to Professor
    Taylor, who is a lot smarter than I am. Thank you.
        [The prepared statement of Dr. Selgin can be found on page
    67 of the appendix.]
        Chairman Huizenga. With that, your time has expired, Dr.
    Selgin, but we are very pleased to--
        Mr. Selgin. Oh, thank you, sorry.
        Chairman Huizenga. --welcome Dr. John Taylor back to the
    subcommittee, and we look forward to your testimony. With that,
    you are recognized for 5 minutes.

    STATEMENT OF JOHN B. TAYLOR, MARY AND ROBERT RAYMOND PROFESSOR
                  OF ECONOMICS AT STANFORD UNIVERSITY

        Mr. Taylor. Thank you, Mr. Chairman, Ranking Member Moore,
    and other members of the subcommittee, for inviting me to talk
    about this important but complicated subject, interest on
    reserves and the Fed's balance sheet. Since reserves are such a
    large part of the Fed's balance sheet, I thought maybe we
    should look at the balance sheet to begin. So I put a picture
    on the front page of my written testimony. I have simplified it
    a bit, but basically it is the main issues.
        If you look at that, you can see that the size has
    increased. Measuring by assets it has gone from $842 billion to
    $4,478 billion. Part of that is because currency has increased.
    Currency has gone from $758 billion to $1,407 billion. That is
    not unusual; that is the growth of the currency.
        What is unusual is this gigantic increase in securities,
    purchase of Treasury securities and mortgage bank securities by
    the Fed, which have gone from $760 billion to $4,234 billion.
    All those figures are in the table.
        Finally, what this has led to is a literal explosion of
    reserves. Reserve balances is what the Fed calls it. From $14
    billion to $2,401 billion. I have a chart on page 2 of my
    testimony which shows that this occurs quite dramatically. This
    occurred of course to finance the purchases of these
    securities.
        In the correspondence with QE1, QE2 and QE3, each
    successively jumping the amount of reserves, is what shows you
    that close correlation between the need to finance QEs and the
    financing through reserve creation.
        When you increase the supply of reserves so much, basic
    economics tells you that is going to drive the market interest
    rate down close to zero. And in fact it did in the fall of
    2008, very rapidly, even faster than the Fed was able to adjust
    its target. There is another chart showing that in my
    testimony.
        But the fact that such a gigantic increase in supply of
    reserves will drive the interest rate down brings us to the
    topic of this hearing. Because to prevent that, the Fed has
    instituted interest on reserves and taken the legal, the law to
    do that.
        I think this disconnect between the interest rate set by
    the Fed through interest on reserves which you could see had
    happened in December, they want to raise the interest rate by
    25 basis points so they raised interest on reserves by 25 basis
    points. No necessary change in the amount of reserves to do
    that.
        So there is a disconnect between the interest rate the Fed
    is setting and the amount of reserves, the amount of money in
    the economy. I think that disconnect is necessary now because
    of this gigantic amount of reserves. There is no choice.
    Otherwise, the rate will fall to zero.
        But as a long-term proposition, I do not think it is a good
    idea to make that disconnect. It does give the Fed another
    tool. But quite frankly it enables the Fed to what I would call
    a multipurpose discretionary institution instead of a rather
    limited purpose rules-based institution, that extra tool gives
    it the ability to do that.
        In this instance, I think it is promising that the Fed in
    their policy normalization principles and plans said that in
    the longer run they will hold no more securities than necessary
    to implement monetary policy efficiently and effectively, and
    that we will hold primarily Treasury securities.
        I would like the Fed to describe to us what effectively,
    primarily, and efficiently means, because it is not clear. I
    think it would be very useful if the Fed said they were going
    to bring that balance sheet down to a level where the supply
    and demand reserves determined the interest rate as in any
    other market, a market that determined the interest rate.
        To do that, to clarify that they are not going to have to
    pay interest on excess reserves in that mode, and remember that
    gigantic increase in reserves will come down substantially. We
    don't know how much it will come down, but come down to the
    point where the interest rate is determined by the supply and
    demand for reserves or money as it has in the past.
        And again, it is true that this gives you an additional
    tool. But I think that additional tool is one of the problems
    we have. It would be important for the Fed to say we are going
    to set monetary policy.
        Not with this extra instrument, which enables it to do so
    many other things including credit allocation, things that are
    properly fiscal policy. It is not the job of the Fed to do
    fiscal policy and credit allocation, but this extra tool
    enables them to do that.
        I say, go back to the basic way it worked before. The world
    is different, it is not exactly the same. I think we will have
    a better Fed, a better monetary policy in that situation.
        Thank you, Mr. Chairman.
        [The prepared statement of Dr. Taylor can be found on page
    83 of the appendix.]
        Chairman Huizenga. Thank you, Dr. Taylor.
        I can see we have a lot of issues to dive into in a very
    short period of time. And with that, I am going to recognize
    myself for 5 minutes for questions.
        I will point out to my colleagues that we had a similar
    panel of Ph.D. economists, concerning the stimulus, and I asked
    the question, who here on the panel believes it should have
    been about half the size? A few hands went up. I asked who,
    here believes it ought to have doubled? One hand went up.
        And the simple fact is that economists are split as to
    whether we had spent half as much or twice as much, we would
    probably end up about right where we are. The question is, do
    you want more debt or less debt as we are moving forward.
        Dr. Eisenbeis, I know you got cut off a little bit, but the
    Treasury is making the payments as a profit was a point made. I
    am curious if you would like to still continue to unpack that.
        I know Dr. Keister had an opposite view of that. And I am
    going to quickly try to move along to Dr. Taylor. And then the
    main question that I have is how in the world are we going to
    unwind all this, and Dr. Taylor was starting to get at that.
    So, Dr. Eisenbeis?
        Mr. Eisenbeis. I think that the proper way to view the
    interest payments, and what Dr. Keister was essentially
    addressing was from the perspective of the financial
    institution, how it deployed those funds once received and how
    it affected the customers.
        I was talking more about how one should view the transfer
    of funds from the Treasury to the Federal Reserve, and
    essentially my main point was that it is the Treasury who is
    paying the interest on reserves.
        When it comes to unwinding the balance sheet, the Fed faces
    a really difficult problem. Because if you just let the
    Treasury securities run off, it would take until about, through
    the normal maturing process, until about 2029 before you would
    return the balance sheet to something close to what I would
    call equilibrium, where essentially mainly you have, as
    Professor Taylor was talking about, sufficient excess reserves
    to conduct monetary policy, and then backing of the currency,
    which would imply a currency level somewhere around $1.3
    trillion or thereabouts.
        Chairman Huizenga. Thank you. Sorry, I have to quickly move
    along. I would like to use a Bloomberg chart that used Dr.
    Taylor's information, but I would be remiss if I didn't take an
    opportunity while having Dr. Taylor here to talk about a rule-
    based Fed policy and sort of where the Federal funds rate was
    and where that dotted line is.
        What the ideal rate is calculated by the Taylor Rule. It
    pretty much shows, it looks like the Fed was somewhere, two to
    maybe three or four quarters behind you, Dr. Taylor, on where
    they should have gone. Do you care to address this and take a
    stab at where we are at?
        Mr. Taylor. Yes, thank you, Mr. Chairman. I think what this
    shows is in the period before the crisis, the interest rate set
    by the Fed was much lower than it would have set had it been
    operating policy as in the 1980s and 1990s. It then caused
    search for yields, excesses in the housing market, and
    eventually the bust. So, it is a real concern.
        If it was closer to the rule, whatever rule, it would have
    been better. During the panic period, they came and brought
    interest rates down very rapidly. It seemed appropriate. But
    since then the rate has been not what I would say rule-based as
    in the past, hanging at around zero, and I think that has been
    a problem.
        Chairman Huizenga. And I know that I had suggested that the
    Chair could create the Yellen rule at some point or another,
    that if there was any kind of rule that needed to be had, and
    that is part of our FORM Act, the Federal Oversight Reform and
    Modernization Act, that has passed the House.
        I would like you to quickly, Dr. Taylor, I know you were
    starting to talk about that on page four and five of your
    written testimony, what happens when the IOER, the excessive
    reserves, interest on excessive, not the required but the
    excessive reserves declines, who benefits from that? You were
    starting to talk about that and Dr. Eisenbeis was a little bit,
    but do you care to address that please?
        Mr. Taylor. At this point, I think the testimony by Mr.
    Eisenbeis makes this clear. It is necessary to do this because
    reserves are so high. So, if they want to raise the rates they
    have to. But it's as if the Fed has been borrowing instead of
    the Treasury, so in that sense it is a wash.
        My concern is that this extra instrument really creates
    many other ways for the Fed to intervene in the economy, and I
    think people don't benefit from that. Maybe one sector will
    benefit, but that is not the job. The Fed is not supposed to
    help certain sectors. It is supposed to help the whole economy.
    That is why it has been successful when it has done that.
        Chairman Huizenga. Just so we are clear, Dr. Selgin, we
    have 5 seconds.
        Mr. Selgin. I actually had another point.
        Chairman Huizenga. Okay, but my time has expired. So with
    that, the Chair recognizes the ranking member of the
    subcommittee, Ms. Moore, for 5 minutes.
        Ms. Moore. Thank you so much, gentlemen, again, for
    appearing. I have to say that the chart you just put up, Mr.
    Chairman, was very confusing to the extent that it was more
    theoretical than anything.
        I guess I am confused, and I guess I will let Dr. Taylor
    and Dr. Keister sort of explain this to us further. I think
    that the Fed has been operating under their mandate.
        The Taylor Rule has been an intellectual discussion, and it
    is not something that the Fed has relied on. And right now, the
    current Fed is operating under that same mandate. And they were
    operating under that mandate in the period that you used to
    calculate your Taylor Rule. So let me start with Dr. Keister.
    Can you respond to the chart we saw?
        Mr. Keister. Sure. I think it is important to remember as
    we focus, for example, on that period in the early 2000s when
    the Fed's interest rate was lower than the Taylor Rule would
    have suggested, that there were very real risks at that time.
        After the crash of the stock market and the collapse of the
    dot.com stocks, there was a very real risk of falling into a
    deeper recession and we were worried about deflation. The fact
    that those risks did not materialize doesn't mean the Fed got
    it wrong; it could be interpreted as meaning the Fed got it
    exactly right.
        It is by easing policy more than would have been suggested
    by a rule that was based on an earlier time period, the Fed
    mitigated those risks and helped the economy recover.
        Ms. Moore. Okay. Dr. Taylor, Dr. Keister essentially said
    that the Taylor Rule really didn't take into account the
    recession, didn't really take into account other risks to the
    system, and I guess I would give you an opportunity for a few
    seconds to respond to that.
        Mr. Taylor. There are many reasons the Fed and people who
    worked at the Fed give to explain why the interest rate was so
    low at that point in time. You just heard one of them. There
    are others: that there were international effects; that we
    couldn't do much about interest rates.
        I think the bottom line is, it is not theoretical. It is
    based on what worked in the 1980s and 1990s until this time. We
    had basically a good, stable economy. We had a few recessions,
    but the ones that occurred were mild.
        Unemployment was much better than what happened in this
    Great Recession. So, that experience has led people, economists
    to think that kind of a policy is not rocket science; it is
    better than one that just ignores it. And when the Fed ignores
    it, it causes problems and that chart shows it big time.
        Ms. Moore. Dr. Keister?
        Mr. Keister. Sure. My main concern about the format is that
    any rule that performed well in a certain time period may not
    perform as well in the future. I think we want the Fed to be
    forward-looking, not backward-looking in its policies, and we
    want the Fed to react as there are changes in the environment.
        Recovering from the financial crisis as the Fed's balance
    sheets continue to normalize, I think we should expect the
    environment to be different than it was, particularly in the
    1980s and the 1990s. And we would like the Fed to have to
    maintain the flexibility to react in the most appropriate way
    as the environment continues to evolve.
        Ms. Moore. I want to change the subject just a little bit
    with my remaining time.
        To you, Dr. Keister, if the Fed's goal ultimately is to
    help our economy grow, we are suffering from low growth. The
    presence of these reserves theoretically, even if there is a
    disincentive to lend it from bank to bank, there still is an
    incentive to provide these resources to economic development
    and to businesses with what the Fed is doing. Am I correct in
    that?
        Mr. Keister. Yes. That is exactly. And that is a point that
    I hope that my little simple example helps clarify. So, when
    the Fed purchases the bond from me, it is holding reserves, but
    it also has a new deposit from me. That doesn't in any way
    prevent my bank from being able to make loans and create credit
    for businesses and consumers.
        By holding more reserves, the bank is safer, and it is
    sounder, but it still has every bit as much incentive to lend
    out to customers.
        Ms. Moore. Okay. Thank you. I yield back--
        Chairman Huizenga. The gentlelady's time has expired.
    With--
        Ms. Moore. --4 seconds left.
        Chairman Huizenga. Yes, I can grant you the 4 seconds back
    if you would like.
        Ms. Moore. No, no. I am just saying that I yielded back.
        Chairman Huizenga. Okay. Point taken. So with that, the
    Chair recognizes the vice chairman of the subcommittee, Mr.
    Mulvaney of South Carolina, for 5 minutes.
        Mr. Mulvaney. Thanks very much, Mr. Chairman.
        I don't know where to begin. A couple of different topics.
    Dr. Taylor, you said something towards the tail end of your
    testimony that the tool, the interest rate on reserves, allowed
    the Fed in effect to set fiscal policy. Did I hear you
    correctly, sir? Could you expand on that a little bit if that--
        Mr. Taylor. Yes. That is what I said. So, given that the
    interest rate can be determined by this interest on reserves,
    means the balance sheet can go wherever it wants to go. Just as
    that is the disconnect that I mentioned.
        So, in that circumstance, the Fed could buy mortgages. It
    could even buy student loans. It could buy automobile loans. In
    fact, of course, it did buy mortgage-backed securities early
    on.
        Mr. Mulvaney. But they can do that--
        Mr. Taylor. But that is a credit allocation issue. It seems
    to me that is the kind of thing that Congress should be
    deciding, which agency should be doing that.
        Mr. Mulvaney. I don't think I am disagreeing with you, but
    they have that ability. I asked Chair Yellen about that, and
    her predecessor as well. They have that ability anyway, don't
    they? They could buy municipal debt if they want to.
        That is one of the authorities they have.
        Mr. Taylor. I think the difference is if the balance sheet
    and the supply of reserves has to be at a level--the supply is
    at a level where it is equilibrating the interest rate. It
    doesn't have the ability to move it anywhere it wants.
        The connection between interest and money is a classic one.
        Mr. Mulvaney. Yes.
        Mr. Taylor. They have severed that. And so, that means
    there is much more ability to expand the balance sheet. They
    could not have expanded the balance sheet to where it is now in
    my picture and still be able to have a positive interest rate
    without this tool.
        Mr. Mulvaney. Dr. Selgin, do you have any thoughts on that?
        Mr. Selgin. Yes, sir. The difference that interest on
    reserve makes is that by encouraging banks to hold large
    quantities of excess reserves it effectively gives the Federal
    Reserve a larger share of savings to play with, and to
    intermediate.
        And that, in turn, means that whatever assets the Fed
    chooses to buy and hold, that its influence on the overall
    allocation of credit is much greater under an interest on
    reserve regime that it would normally be.
        Mr. Mulvaney. Have you gentlemen given any thought to why
    this--my understanding is that when this tool was used in
    December of 2015, it was the first time it had been done. Chair
    Yellen was here before that, and the Fed had anticipated that,
    hinted that they were going to use this tool.
        I remember asking her at a hearing why she expected to use
    that tool as opposed to moving the Fed funds, right? Or some
    other traditional tool, shrinking the balance sheet, for
    example. And she said, well, you know, the answer is what we
    always get. Which is we have many tools available to us. We
    just happened to pick this one this time.
        Do you gentlemen have any thoughts as to why you think this
    tool was used in December of 2015 and not one of the more
    traditional tools? Dr. Selgin?
        Mr. Selgin. The fact is that the Federal Reserve was unable
    to use its traditional tools. Let me go back to when they first
    implemented interest on reserves, just for a moment.
        The original idea was that interest on reserves would put a
    floor on the actual effective Federal funds rate, and that
    would help the Fed to keep its target, which was still above
    zero at that time. It didn't work out that way. The effective
    rate at which actual tradings were occurring continued to be
    below and to fall further below the Fed's target.
        Subsequently, they changed how they described their target
    by saying, the target is now a bend, where the interest on
    reserves is the upper part of the bend, and the lower part is
    either zero or subsequently the overnight repo rate.
        Frankly, it is like an archer who misses a target then
    moves the target, and then says, see, now we are meeting the
    target again.
        Mr. Mulvaney. I follow that. But, again, why? Why would
    they use that tool and not another one? Why were the other
    tools ineffective?
        Mr. Selgin. The alternative would have been to raise
    interest rates by selling assets. And because the Fed had
    acquired such a large proportion of mortgage-backed securities,
    which it did not dare sell, and could not sell for much, and
    because of long-term Treasuries it held, it feared the balance
    sheet repercussions to itself, the capital losses, and also the
    consequences for the values of these securities in the market.
        Mr. Mulvaney. Does the Fed have to mark the assets on its
    balance sheet to market occasionally or not?
        Mr. Selgin. No, it does not. And it is an interesting
    question because the Fed, unlike normal banks, can actually
    become insolvent and have negative capital without closing
    shop. The problem is in the income statement where, of course,
    it would have to go hat-in-hand to Congress if it were not able
    to earn enough income to cover its operating expenses.
        Mr. Mulvaney. I hope we get a second round. I thank the
    chairman. Thank you, gentlemen.
        Chairman Huizenga. Thank you. The gentleman's time has
    expired. With that, the Chair recognizes Mr. Foster of Illinois
    for 5 minutes.
        Mr. Foster. Thank you. Let us say, Dr. Eisenbeis, if the
    Fed just let all of the assets run down, that it would be
    around 2029, I think you said that. And is that sort of similar
    what is happening over the last couple of years where, I
    believe, they are trending down?
        Mr. Eisenbeis. No, they haven't been trying to reduce the
    balance sheet at all. They have been reinvesting and maturing
    the portfolio--
        Mr. Foster. Then we--
        Mr. Eisenbeis. So, they have not yet made the decision to
    stop reinvesting and let the balance sheet run off. So, my--
        Mr. Foster. Okay.
        Mr. Eisenbeis. --number assumed that they would do that
    now. The longer they postpone then that 2029 figure gets pushed
    out further.
        Mr. Foster. Okay. And is there an understanding, an
    agreement on what would happen if they let it run down on the
    trajectory you talked about, unload things faster or slower?
    What effects that would have on short-term, that effect, by
    itself, on short-term and long-term interest rate?
        Mr. Eisenbeis. In the short run, what it would do is if the
    Treasury in particular maintained the volume of outstanding
    securities, this would put more collateral into the
    marketplace, and relieve some of the pressure on collateral and
    have an implication for interest rates.
        So, right now, the argument is that size of the balance
    sheet because of the interest rate impacts we have been talking
    about is actually a tightening. This would actually free up and
    be a little bit more of a moderating force on interest rates as
    a whole.
        Mr. Foster. Is there a limit on how rapidly you think they
    should unwind the balance sheet?
        Mr. Eisenbeis. The problem is that they risk if they have
    to unwind it faster and if that is necessitated because of
    restrictions on interest payment on reserves or inability to
    sort of sterilize the excess reserves, if the money supply
    started to grow too rapidly, then they would have to sell
    assets.
        And if interest rates are rising during this environment,
    which presumably would be the case, they would have to sell
    those assets at a capital loss. And rather than recognizing the
    capital loss on their balance sheet, they would be able to
    create what is called a deferred asset account or a negative
    asset account.
        And try to get your head around what a negative asset
    account is.
        Mr. Foster. I will. That is the end run guys.
        Mr. Eisenbeis. But if you match that negative asset account
    against their capital account they could quickly go insolvent
    as Dr. Selgin has indicated. And how would the world respond to
    seeing a negative--
        Mr. Foster. Okay. So it sounds like the default scenario
    here would be just to let everything run down by about 2029,
    and then use other tools to regulate interest rates as it, sort
    of, gradually. Is there anyone who believe that scenario would
    not work and could not be made to work?
        Mr. Eisenbeis. My problem with that is 2029 is a ways away,
    and that the whole period is it almost becomes permanent, that
    particular method of controlling the interest rate. I think
    that it would be far better to bring the balance sheet down,
    bring reserves down more rapidly if it is done strategically,
    clearly, I don't think it should be a problem.
        There is huge controversy about how much Q.E. actually did
    anything to interest rates. I think it sometimes surprised the
    market and moved rates, but if it was clear I think they could
    reduce that balance sheet much more rapidly than 2029.
        Mr. Foster. Okay. Dr. Selgin, you indicated at one point
    that the Federal Reserve couldn't sell the MBS's that it owned.
    Weren't these government-backed MBS's? Was there ever a point
    when they could not sell them?
        Mr. Selgin. The problem isn't that they can't sell them;
    the problem is they can't sell them for anything like what they
    are valued at on their books. So it is the problem that we have
    been talking about, about the Fed bearing losses on those
    securities by selling them.
        Mr. Foster. Did this have anything to do with the fact that
    they were mortgage-backed securities, or just the fact that--
        Mr. Selgin. They were mortgage-backed securities
    purchased--
        Mr. Foster. But it had nothing to do with the mortgage
    market directly--
        Mr. Selgin. No, they were mortgage-backed securities
    purchased during the crises precisely because their values at
    the time were doubtful and they were purchased as part of an
    emergency effort to help the financial institutions that had
    been holding those assets.
        Mr. Foster. Okay. Yes. I may have some follow-up questions.
    I don't completely understand that risk because I thought at
    the time that these were government-backed MBS's, and, in fact,
    it was not noticeably different than buying other government-
    backed assets.
        Anyway, okay. Let us see. Just a final observation on the
    very first plot that showed the deviation from the Taylor Rule.
    I think if you look at point of maximum deviation, and then
    think about when elections were being held, I think you come up
    with an interesting argument for an independent Federal
    Reserve. And with that, I will yield back.
        Chairman Huizenga. The gentleman yields back. Point well
    taken. With that, we will be going to Mr. Pittenger of North
    Carolina for 5 minutes.
        Mr. Pittenger. Thank you, Mr. Chairman. And I thank each of
    you for being with us today. Mr. Eisenbeis, if the Fed's
    balance sheet strategy was working, then why haven't normal
    market conditions returned even after 8 years of financial
    panic?
        Mr. Eisenbeis. Could you repeat the question, sir?
        Mr. Pittenger. If the Fed's balance sheet strategy was
    working, then why haven't normal market conditions returned,
    even after 8 years?
        Mr. Eisenbeis. That really depends upon how they employ the
    tools that they use and what the growth rate in the economy is,
    and how sick of it, if we are on the present path there is a
    chance that they could get into a normalization situation, but
    I think the risk is that if the economy starts to pick up
    growth because it is one thing if they are growing at 2
    percent.
        But if the economy starts to grow, that means that
    inflation is going to potentially start to pick up. And then,
    they are in a bind as to what to do.
        Mr. Pittenger. As such, what is stopping the Fed at this
    point from naturally winding down the balance sheet?
        Mr. Eisenbeis. I think they are really in a risk adverse
    situation and risk management at this point in time. They are
    just really cautious about the fact that they have not been
    achieving their inflation objective.
        The labor market clearly is improving and doing quite well
    by comparison, but they are essentially wanting to keep their
    foot on the throttle from their perspective to get inflation up
    to their 2 percent target.
        Mr. Pittenger. Thank you. Dr. Selgin, in terms of economic
    opportunity how much damage is being done from leaving the
    balance sheet too big for too long?
        Mr. Selgin. I wish I could give you an answer to that
    question. What we can say is that the holding of, or the
    allocation of so much savings to the sectors that the Fed's
    balance sheet is supporting certainly does not contribute to
    productive investment as it might if the same savings were
    allocated by the commercial banks and other private lenders.
        We know that none of it is supporting lending, commercial
    lending of any kind. It is certainly not supporting lending to
    small businesses that is regarded as very important to a
    recovery. I believe it is an important factor, by no means the
    only important factor in the sluggish economy.
        And I believe it is one of the reasons why we have, despite
    the Fed's seemingly aggressive monetary expansion, we haven't
    really seen a very robust recovery coming out of that. The best
    that people can say is that it is not as bad as Europe. This
    doesn't seem to me to be a very clear endorsement of what the
    Fed has been up to.
        Mr. Pittenger. Thank you. And in terms of monetary policy
    independence, what damage is leaving the balance sheet too big
    for too long?
        Mr. Selgin. Sorry, could you repeat that?
        Mr. Pittenger. In terms of monetary policy independence,
    what damage is it to leave the balance sheet too big for too
    long?
        Mr. Selgin. That depends on how Congress responds to having
    such a big balance sheet and having the Fed maintain it, of
    course. I think that there is no reason why the Fed can't
    continue to be independent. But I think that Congress should
    limit its dependence to the extent of trying to tell it that it
    should not stay in this situation forever.
        If it is undermining Fed independence to merely tell them
    to go back to business as usual and to do it as quickly as
    possible, well, then I say the Fed has rather too much
    independence to begin with.
        Mr. Pittenger. Thank you. Dr. Taylor, to what extent does
    the remarkable expansion of the Fed's balance sheet mitigate
    the financial crises?
        Mr. Taylor. I think in the fall of 2008 when they provided
    lender-of-last-resort loans in the panic, in this panic period,
    it seems that was overall good monetary policy. And that is
    when the balance sheet first began to expand.
        However, those liquidity facilities drew up very quickly. I
    think after that, certainly after early 2009 I raised big
    questions as to whether that did any good at all. There are
    lots of studies. I did an early study back in 2009 which said
    it was not effective. Some argue it is actually
    counterproductive.
        Mr. Pittenger. To what extent then did it exacerbate the
    problem?
        Mr. Taylor. I think it is exacerbated the problem because
    it really delayed the time where the Fed could get back to the
    kind of policy that worked so well in the past. It has been a
    reason for them not to go back. And just this very discussion
    is they find it so difficult to reduce the balance sheet.
        It shows you one of the concerns many of us had about the
    increase in the balance sheet in the first place. It is almost
    like a we-told-you-so type of thing. Although, I am not doing
    that right here.
        Mr. Pittenger. Thank you. My time has expired. Unless the
    chairman wants you to comment?
        Chairman Huizenga. The gentleman's time has expired. With
    that, the Chair recognizes Mr. Himes of Connecticut for 5
    minutes.
        Mr. Himes. Thank you, Mr. Chairman. And I am not sure I
    have a lot in the way of questions. But I am here and I am
    concerned about this because big picture, what we are talking
    about is something that maybe some of my colleagues don't
    appreciate, which is the profound importance of the
    independence of monetary policy, and of a flexible central
    bank.
        Most Americans can understand why a strong military is
    important to national security, and why high taxes can affect
    economic vibrancy. Most of them don't necessarily get the
    historical fact that an independent and flexible and smart
    central bank is the very cornerstone of a functioning
    capitalist economy.
        And I can't help but feel that this hearing and the ongoing
    Fed bashing by my Republican friends and the scaling back of
    authorities and the audit the Fed are all part of an effort
    that if they are joined, the legacy of those who join in on
    that effort will be to erode one of the very cornerstones of
    this country's vibrant economy, which is an independent
    monetary policy.
        If we had had a Fed-caused disaster, I would understand why
    we would be having this conversation. But the reality is that
    in the last 8 years or so, the Fed was the one adult in the
    room. And I made this point in my opening statement.
        Congress failed in its responsibility to provide enough
    fiscal stimulus to do what it should have done. In the absence
    of good fiscal policy, and I am going to come back to this
    because the chairman took exception to what I characterized as
    an economic consensus, the Fed was the only game in town.
        And it is a fair thing to question what their authorities
    are, and to provide oversight, I have no doubt. But the reality
    is that their actions had results which show themselves in the
    fact, Mr. Selgin, that our economic recovery in combination
    with the decline of the deficit is the envy not just of Europe,
    but of every industrialized country.
        So we have been--if we had gotten it wrong and we are at
    the bottom in that stack, I get this. But, Mr. Chairman, and I
    don't mean to pick on the chairman on this, holds up as his
    counterpoint to my contention on the stimulus that a bunch of
    witnesses, four or five, selected, of course, by the chairman
    himself and the Majority party, raised their hands to say they
    didn't like the stimulus.
        Reality matters. I counter to the chairman the initiative
    of global markets, which is a survey conducted by the
    University of Chicago, hardly a hotbed of liberal thought, has
    surveyed economists across the political spectrum on the
    stimulus for a long time.
        Its most recent survey had 36 out of 37 economists saying
    that the stimulus actually improved the economy and reduced
    unemployment. Reality matters.
        And the reality is that we are criticizing the very people
    and eroding the monetary independence of the very people who
    were the one adult in the room with scare tactics. Ooh, some of
    this money is going to foreign banks.
        Well, guess what? Toronto Dominion, T.D., they extend
    mortgages in my district in southwest Connecticut. I know it is
    scary to say that we are sending money to foreign banks, but it
    is actually, as a politician, a little bit, for an economist, a
    little bit of a cheap political trick.
        The reality is that this policy has worked. Now, again,
    most of my constituents and most people here don't really
    understand what we are talking about. It is hard, this stuff.
    So, let me offer an analogy.
        We had a major car crash. We talk about the crash a lot.
    Let us envision this as a car crash. What happened in 2008 was
    a car crash where four people are bleeding in the street. And
    Congress said, instead of four ambulances we are sending you
    two.
        So, two people get taken off. This is the stimulus. And
    there are two people bleeding in the street. And the Federal
    Reserve says, geez, there are people bleeding in the street. We
    are going to send some helicopters, as they do from time to
    time. And, yes, that is extraordinary. We probably shouldn't do
    it for every car crash. But we didn't do what we needed to do.
        And so, now you have helicopters carrying people to the
    hospital. Nobody says that is the right way to do it, but it
    was the only way to do it. And the patients all lived. And now
    we are saying, my God, the helicopters were expensive, and
    there is glass in the street. And it scared the neighbors. We
    shouldn't use helicopters.
        Folks, it was the only game in town. Now--
        Chairman Huizenga. Will the gentleman yield?
        Mr. Himes. I will yield when I am finished.
        This was a tool that worked in literally a crash. And so, I
    appreciate the equanimity that Dr. Taylor is showing in
    particular. I don't think anybody wants this to be a standard
    tool, but, please, Mr. Chairman, and then I will yield, let us
    be very, very careful about scaling back authorities that had
    everything while we were negligent to do with the recovery, and
    that we may need, heaven forbid, but we may need in the future.
        And, yes, I will yield to the chairman.
        Chairman Huizenga. Thank you. I appreciate that. And I am
    assuming that if one is intellectually honest, one will also
    acknowledge that the drag on the recovery of the economy has
    oftentimes been linked to the Affordable Care Act (ACA). It has
    oftentimes been linked to the regulatory environment that has
    been created, the tax policy that even our own President has
    said needs to be reformulated.
        Mr. Himes. I will reclaim my time, and say, yes, those
    things have been linked to the recovery by my friends in the
    Republican Party. If you actually read, for example, the
    Federal Reserve, who we are talking about, they will tell you
    that this is a crisis of aggregate demand.
        They won't mention the Affordable Care Act. They won't
    mention taxation. They will mention it is an issue of aggregate
    demand. With that, I note that I am out of time.
        Chairman Huizenga. The gentleman's time has expired. With
    that, the Chair recognizes the gentlelady from Utah, Mrs. Love,
    for 5 minutes.
        Mrs. Love. Thank you, Mr. Chairman. Just a few questions
    and then I will yield back the remainder of my time if I have
    some time. Thank you for being here.
        As I have observed, the Fed has consistently and often
    badly overshot its mark in projecting economic growth,
    reflecting a misplaced belief that repeated rounds of
    quantitative easing, a $4.5 trillion balance sheet, and low
    record policy rates, could reliably get our economy back on
    track.
        Earlier this year, for instance, Forbes even mentioned that
    at the beginning of every year since 2008, economists have
    predicted its actions would produce a robust expansion. And
    each year has had to sharply downgrade those expectations.
        I guess the first question is, do you agree with that
    assessment? Are you seeing the same thing, Dr. Taylor, when it
    comes to the Fed's predictions?
        Mr. Taylor. Yes. They have over-forecast the growth rate
    consistently through this period, I think to some extent
    thinking that their policy would be more effective. They will
    punt for other reasons, but that is a big factor.
        Mrs. Love. Okay. So, I guess the question here, the basic
    question for me is why, despite such sophisticated models, does
    the Fed consistently miss the mark? And why not use those
    models to fuel a robust economy, or a robust recovery, as
    opposed to putting the brakes on economic opportunity? Dr.
    Selgin?
        Mr. Selgin. If they had good models, they could do what you
    say the problem is that their models are not very good. And
    when they employ wrong models, they take wrong policy actions,
    like the December rate hike, which was, at best,
    counterproductive.
        Mrs. Love. So, you are thinking that the models are just--
        Mr. Selgin. Yes. And--
        Mrs. Love. --not very good models.
        Mr. Selgin. --the fact is that the Fed--the Fed can do
    damage when it employs bad models, and it is experimentation
    often backfires.
        And this is why in Fed independence, to conduct monetary
    policy in the sense of being free to set the policy rates,
    which is the normal understanding of independence, to determine
    general monetary conditions, is not the same thing as Fed
    experimentation with activities and programs that it has never
    engaged in before. Independence isn't license.
        Mrs. Love. Okay. So, I guess this is my final question
    because I think the important thing in the work that we do
    here, is to try and figure out how this relates to the everyday
    person. What does this mean for the family who is sitting at
    the kitchen table if we continue to have these types of
    practices, and these models that are not working?
        What does that mean for the family? Did you have something
    you wanted to add, sir?
        Mr. Eisenbeis. I would like to respond briefly in the sense
    that you have to understand that the models that were being
    employed did not include experiments and experience like the
    Great Recession that we had.
        So, the data that are underlying the models, essentially
    mean that the current environment that we were in is out of
    sample forecasting, and the models didn't incorporate the kind
    of behavior and responses that the economy was in at this
    particular point in time.
        Mrs. Love. So, you are saying it was behind, we were behind
    the ball?
        Mr. Eisenbeis. There is no way you can generate data that
    would have essentially allowed the Fed on a current basis to
    revise the models in a way to capture the current economic
    environment.
        So, this is a characteristic of forecasting as a whole. We
    know that based on experiments that I did a long time ago that
    showed that the Fed's models essentially are as good as anybody
    else's, and better than most.
        But when you have an environment and an economic
    environment degenerating out of the normal behavior, you are
    going to have these kinds of errors. And there is really
    virtually no way to fix it.
        Mrs. Love. Okay. I have 25 seconds. Dr. Selgin, again, what
    does this mean? If we continue, what does this mean for the
    family who is sitting at home? How does that affect regular
    hardworking Americans?
        Mr. Selgin. The biggest effect comes through the lack of
    private investment, productive investment, small business
    investment, as a result of the fact that the Fed, through its
    encouragement of banks to hold reserves, and they cannot both
    hold reserves and loan.
        They are either holding one kind of asset on their balance
    sheet, or another, in real terms. This has a drag on the
    economy. And I would like to also add to that, with respect to
    what Congressman Himes said, the Fed did not add an ambulance
    to the batch when it paid interest on reserves. It took one
    away.
        Interest on reserves in 2008 was a contractionary measure
    which took away from aggregate demand, and its avowed purpose
    was to keep banks from lending the new reserves that were being
    created at the time.
        So, if you want aggregate demand to grow, and I think it
    desperately needed to grow at that time, if you want to have
    enough ambulances, you don't want the policy of interest on
    reserves implemented in the middle of a contraction.
        This is simply getting reality, which does, indeed, matter,
    wrong.
        Mrs. Love. Thank you. My time has expired.
        Chairman Huizenga. The gentlelady's time has expired.
        Mrs. Love. Thank you.
        Chairman Huizenga. With that, the Chair recognizes the
    gentleman from Washington, Mr. Heck, for 5 minutes.
        Mr. Heck. Thank you, Mr. Chairman.
        When it comes to this arcane subject of the Fed's authority
    to pay interest rates on reserves, I will admit in all candor
    that I am reminded of a couple of Mark Twain's phrases, one of
    which was, it's better to keep my mouth shut and allow people
    to think me ignorant then to open my mouth and remove all
    doubt. This just seems to me to be a question of how many
    angels can dance on the head of a pin.
        But I am heartened by the turn of this conversation which
    has become what is it that we can do to grow our economy at a
    faster rate than the relatively anemic growth that we have been
    experiencing. That fact not withstanding that I think we are
    now in our 74th straight month of private sector employment
    addition.
        Somebody used the other oft-used phrase earlier: This isn't
    rocket science. And when it comes to what it is that increases
    gross domestic product growth, I don't think it is rocket
    science either. If you want to increase aggregate demand, here
    is a real simple formula, this isn't hard: Increase employment
    and increase wages.
        Give America a raise, and give more people jobs. And that
    is what we learned in undergraduate school, logic class
    Tautology, A equals A. Why? Because our economy is nearly 70
    percent demand driven by consumers.
        So, if you want to increase the rate of growth in this
    economy, give more people jobs and increase wages. Voila.
        Now, there has been some reference here, which seems off
    topic to me, with all due respect, to regulatory environment
    and the like. Nobody has talked about the fact that the minimum
    wage has been stuck at $7.25 for I don't know how many years.
        I would ask every single person sitting in this room, or
    watching or listening, do you want to live on $7.25 an hour?
    Try that out. See what it is like to try to pay your rent and
    buy your food and provide for your children at $7.25 an hour.
        You want to move this economy faster? How about we stop
    underinvesting in our Nation's public infrastructure?
        In my district, fully 25 percent of the bridges are, from
    an engineering standpoint, deficient. Do you want to increase
    the economic growth in South Puget Sound and Washington State?
    Then complete State Road 167 into the Port of Tacoma, which
    will connect the largest warehouse district, the second largest
    warehouse district on the West Coast; to the largest container
    port in the Pacific Northwest.
        Fortunately, the State Legislature passed a transportation
    improvement bill to do just that. Bipartisan, but that will
    increase growth.
        You want to increase growth in South Puget Sound? Increase
    aggregate demand, increase the growth rate of the GDP? Then
    relieve the congestion on Interstate 5, around joint base Lewis
    McCord, also included in this last Transportation Improvement
    PAC.
        Yesterday morning, I drove from Olympia, Washington to
    SeaTac--52 miles. It took me nearly 2 hours. No accidents. On
    an interstate freeway.
        Ask yourself how much time people are sitting in traffic,
    moving at a glacial pace, not being home with their families
    for dinner, or not getting their goods to market, because we
    are under-investing in public infrastructure.
        Now, if there is one thing this entire Congress--Democrats
    and Republicans, and Liberals and Conservatives--ought to agree
    on it is that 2 percent isn't cutting it. It is an aggregate-
    demand economy.
        Let us sit around here, and talk about how many angels
    could dance on the head of a pin, interest rates and excess
    reserves. But if we want to really move this economy forward,
    if we want to increase the GDP, then we need to increase wages
    and give more people jobs.
        I wish to associate myself with the remarks of the
    gentleman from Connecticut. With that, I yield back the balance
    of my time.
        Chairman Huizenga. The gentleman yields back. With that,
    the Chair recognizes the gentleman from Minnesota, Mr. Emmer,
    for 5 minutes.
        Mr. Emmer. Thank you, Mr. Chairman. And thanks to the panel
    for being here today.
        My understanding is we are talking about the tool, as it
    has been referred to, that the Federal Reserve was given as
    part of some legislation passed in 2008, to pay interest on
    reserves.
        And that, supposedly, was recommended many years earlier by
    Milton Friedman. But correct me if I am wrong, I don't think
    Milton Friedman suggested pay, not only on required reserves,
    because there is an implied tax, but I don't think Milton
    Friedman suggested paying interest on excess reserves. Am I
    incorrect about that?
        Mr. Selgin. I can't speak to what Mr. Friedman actually
    said on the specifics, but I am sure that he would have argued
    that it is the required reserves that really impose a cost on
    banks.
        But that is mostly because banks normally hold, in this
    country, very few excessive reserves. And the only way you can
    get them to hold more than a few, is by paying them interest on
    reserves.
        Mr. Emmer. And let us--
        Mr. Selgin. On excessive reserves.
        Mr. Emmer. Thank you, Dr. Selgin. Because let us say, if
    you go based on the facts, in 2007 the required reserves
    averaged $43 billion. Excessive reserves, at that time,
    averaged only $1.9 billion. And with the exception of 2 months
    in our country's history, that had been the case for 50-some
    years.
        In fact the case, as I understand it, is the excessive
    reserves typically accounted for about 10 percent of the total
    required reserves, up until this law was passed. And now, we
    have this huge balance sheet with $4.5 trillion in--the panel
    has told us that you have some ideas of how we are going to
    correct this.
        Before I leave it, though, Dr. Selgin, I think the
    important part is that the important point you made is not a
    partisan point.
        It is when you have all of this money sitting on reserve,
    apparently paying more money that maybe it could get out in the
    marketplace. You have the government distorting the
    marketplace, and that money isn't being put to work for better
    jobs, and higher wages, and new opportunities.
        Is that the point you were trying to make?
        Mr. Selgin. It is. And, again, what is relevant is not the
    absolute amount of reserves, which would go up necessarily. It
    is the amount of excess reserves, and how that has increased.
    And how it has increased in proportion to the overall size of
    banks' balance sheets. We would take the bank's balance sheet
    overall size as given.
        The question is, what are they doing with the resources
    available to them? If they are devoting them to holding
    reserves, then the investment is channeled to the Fed, and
    channeled to the sectors the Fed supports.
        If they don't do that, then they are channeling the
    investment themselves, directly, to other uses; which generally
    speaking, will be more productive. This is a mathematical
    certainty.
        Mr. Emmer. Dr. Taylor, quickly. And I am sorry about the
    short time, cause I would like to hear this from everybody, but
    of the different ideas that we have heard of how you reduce
    this excessive balance sheet, you start to rebalance it, if you
    would.
        By divesting assets, allowing assets to mature and run off
    these different ideas, which one would be the best? And do we
    risk, if it is done improperly, inflation or deflation
    circumstances?
        Mr. Taylor. I think it requires all these things. In
    addition, I would say some selling, some of the securities. In
    a way that is made clear to the markets. So the Fed seems to be
    worried about doing that, but I think you want to go further
    than, just, let it run out to 2029. So, I think that is the
    most important thing.
        And also, I think, having a goal, that is where they want
    to go. There is this statement about normalization that they
    have, but it is not clear about where they are going
    eventually. I think that is very important so then, people can
    plan.
        If I just add an example of an analogy. Back when there was
    the controversy about the Taper Tantrum, that is because the
    then-Chair of the Fed wasn't very clear about what they were
    doing with the balance sheet.
        As soon as they clarified, and this is with the new Chair
    more, it was an easy thing to start, just to have the Taper. It
    didn't cause disruption.
        I think it is very much the same now, as if they were clear
    about how they would reduce the balance sheet. I long ago
    argued that by the time the Federal Funds rate is at 2 percent,
    the balance sheet should be at the level where that rate is
    determined by the supply and demands reserves.
        I think that is kind of a goal that they could set. It is
    consistent with the tightening that they are planning on. It
    would be well-understood. I think it would work fine.
        Mr. Emmer. Thank you. I see my time has expired.
        Chairman Huizenga. The gentleman's time has expired. With
    that, the Chair recognizes the ranking member of the full
    Financial Services Committe, Ms. Waters, for 5 minutes.
        Ms. Waters. Thank you very much, Mr. Chairman. I am very
    pleased about this hearing today. This is just the beginning of
    a long-term debate that we are going to have on the Fed.
        Let me just say that, when we had Federal Reserve Chair
    Janet Yellen here, she made it clear that allowing the Federal
    Reserve to pay interest on reserves as long as there is an
    abundance of reserves in the banking system, is absolutely
    critical to its ability to gradually and predictively move
    rates up as warranted, in the current environment.
        Now, I think it is important for me to say, at this point,
    that I have spent considerable time with Chair Janet Yellen,
    wanting to make sure that I understood not only quantitative
    easing and what it had done, and what it had not done, but I
    was very interested in this payment of interest on reserves and
    excess reserves, as it has been alluded to here.
        I have the greatest confidence in her. And I absolutely
    believe that she is making and has made some tremendously
    important decisions that have been extremely helpful.
        I think there is just a basic philosophical difference
    between this side of the aisle and that side of the aisle on
    whether or not the Fed should be independent, and I absolutely
    believe in the independence of the Fed and I absolutely believe
    that what has taken place here, particularly with quantitative
    easing and that program, that reduce long term Treasury yields
    by more than a full percentage point.
        It is important for us to know and understand lower, longer
    term rates also support a strong economic growth, help the
    stock market recover, allow underwater home owners to regain
    equity in their homes, and have positive effects on consumer
    spending through the wealth effect.
        Lower long-term rates also make business investment more
    affordable and make the trade balance more favorable by
    lowering the value of the dollar.
        So, I am going to turn to you, Dr. Keister. In your
    assessment, would all of these benefits associated with the
    Fed's quantitative easing program have been achievable if the
    Fed knew it wouldn't have the ability to manage short-term
    rates through interest on excess reserves as part of the
    normalization process?
        Mr. Keister. No, absolutely not. The ability to pay
    interest on reserves, including on excess reserves, I think,
    was critical in encouraging, in allowing the Fed to know that
    when the time came to raise interest rates, it could raise
    interest rates, regardless of the size of its balance sheet.
        And for that reason, it was able to undertake these large-
    scale asset purchases which, as you mentioned, help lower long-
    term interest rates and increase the flow of credit to
    consumers and households.
        If I may, I would like to make one other point that I think
    has gotten a bit lost in this discussion. So, Dr. Taylor had
    emphasized that allowing the Fed to pay interest on excess
    reserves going forward gives the Fed an additional policy tool,
    which is absolutely correct. And then he discussed some ways
    the Feds could potentially misuse that tool.
        But he also mentioned that the Fed's response to the early
    stages of the financial crisis in the fall of 2008 was proper.
    In response to a financial panic the Central Bank should do
    what it, what the Fed was chartered to do in the original
    Federal Reserve Act, that is provide an elastic currency,
    increase the supply of bank reserves with a supply of liquid
    assets when there is plight in the safety of the banking
    system.
        If the Fed were to lose the ability to pay interest on
    reserves, we would be back in the situation we were in, in
    2007. The Fed would face a conflict between being able to
    provide liquidity to the market in periods of financial turmoil
    and maintaining the interest rate that is appropriate with the
    stance of monetary policy.
        The Congress accelerated the authorization of the Fed to
    pay interest on reserves precisely to allow it to arrest the
    crisis in the fall of 2008. But had the Fed had that authority
    earlier, it would have been able to provide a much stronger
    market-based programs of liquidity assistance which may--it is
    hard to know for sure--have been effective in helping to
    prevent the worst of the financial crisis and thereby, make
    some of the stronger programs that we saw later unnecessary.
        Ms. Waters. Thank you, very much. I noticed that the word
    ``experimentation'' has been used several times here and I
    think I would object to calling the quantitative easing and the
    interest on excess reserves ``experimentation.''
        It is flexibility, as I see it, and understand it. And I
    know that Mr. Huizenga has proposed, or is proposing that,
    somehow, we should absolutely bow down to the Taylor Rule, and
    maybe if there is something extraordinary happening, like 2008,
    we could have flexibility.
        So, I know you don't have time to answer that, but I think
    that is something that should be considered in our discussion
    as we continue to talk about the independence of the Fed. I
    yield back.
        Chairman Huizenga. The gentlelady yields back. Time has
    expired. I will point out that is actually not what the format
    says, but that is for another conversation. So with that, the
    gentleman from Indiana, Mr. Stutzman, is recognized for 5
    minutes.
        Mr. Stutzman. Thank you. Thank you, Mr. Chairman, and it is
    good to see the panel. Dr. Taylor, it's good to see you, and I
    have enjoyed listening so far to the conversation.
        One of the things that people back home often expect from
    Washington is that it not stand in the way of progress, that it
    not stand in the way of growth. And if you look at history that
    we have here in this country, and the United States has been
    blessed with different periods of tremendous growth but you
    look at what we have also seen in the past 10 years.
        I am looking at an article right now that says that the
    United States has record 10th straight year without 3 percent
    GDP growth. And I think that this is only, this is only the way
    that things are going to feel better, be better in the, across
    the country.
        When you talk to families in Indiana, in the 3rd District,
    they are wondering why things aren't better. What is standing
    in front of growth?
        And I think there are a variety of things to address that.
    I think it is an interesting thing, too, that while it may not
    just be Fed policy that affects growth, I think also you see
    the regulatory environment that we are dealing with out of
    Washington has slowed growth tremendously. Industries just
    don't know what to do.
        But I think that when you look at the facts, and if you
    take a macro view of where this country has been over the last
    100 years with the institution of the Fed, there are two
    periods in history. And I think this is what we all want. We
    all want to figure out what gives us growth, because that is
    the way the country is only going to move forward. That is the
    way families are going to do better.
        And there were two periods in Federal Reserve history when
    we experienced a tremendous amount of growth and that happened
    to be in 1923 to 1928 and then in 1985 to 2003. In the first
    case, the Fed operated under some form of the Gold Standard,
    and in the second case, under the Taylor Rule, more or less.
        And those were two periods where we saw tremendous growth.
    And I think that is what is lost on Washington a lot of times,
    is the fact that families are struggling today, that America
    could be doing a lot better, that we are not reaching our full
    capacity.
        To go 10 years without 3 percent GDP growth is really
    remarkable. And I think we all should be asking the question,
    why? Why is that the case? And I know, we all want what is best
    for families. We want what is best for this country, for us to
    deal with the debt, for us to deal with increased wages.
        Something is going to have to give, and I think that this
    hearing is particularly interesting because it deals with the
    Fed, which I do believe affects our economy.
        Dr. Taylor, I would like to start with you about the
    balance sheet of the Fed. Why not just naturally wind it down?
    What is keeping the Fed from winding down its balance sheet and
    I think that the more strength we see, the more opportunity and
    ability in the private market is going to give.
        I can feel it when I go home. There are people who want to
    grow, but can you talk a little bit about the Fed and just why
    don't they naturally wind down their balance sheet?
        Mr. Taylor. I think they could. I think they are reluctant
    to, for the same reasons; they think the expansion was
    beneficial and we heard a couple of statements about that
    already. I don't think it was so beneficial.
        To me, they can undo this, as long as it is gradual,
    certainly they can take some time to do it and be clear about
    it. I think that is the way to go.
        I think that there are, as you say, many other things in
    policy and I do think this regulatory reform, I do think the
    fiscal reform, the tax reform, and all those things are very
    important. They go together, to me.
        You mentioned these periods of time. Well, those are
    periods where you also saw good and bad other kinds of policies
    too, so it all goes together in my view.
        Mr. Stutzman. I don't know if anybody else would like to
    comment. Go ahead.
        Mr. Eisenbeis. Yes. There are really two underpinnings for
    growth. One is for real economic growth, and one is for
    population growth, which contributes to economic growth and the
    second is productivity.
        Productivity has really slacked off and productivity growth
    has slacked off and to me, that is an area where policy focus
    should be as to what is holding back productivity growth at
    this point.
        Because, on the one hand, we have technology and a lot of
    things in place that look very promising, but why isn't
    productivity growth expanding? The Fed can create a climate for
    growth but it can't deal with productivity growth and some of
    the key underlying determinates of real GDP growth.
        Mr. Stutzman. Absolutely. And I agree with that, but again,
    a sound fiscal monetary policy is part--it has to be one of the
    top priorities for us, especially in this committee, but
    knowing energy.
        Energy doesn't know what to do right now because of the
    policies out of Washington. Manufacturing--every time
    businesses turn around, they just feel another sort of
    regulation piling on them and that is what is slowing us down.
    But for these purposes, the best thing we can do is to make
    sure the monetary policy is fiscally sound. Dr. Elgin?
        Mr. Selgin. Yes.
        Mr. Stutzman. If it is okay with the chairman.
        Mr. Selgin. Let us remember that this is, you can achieve
    any level of monetary policy, any degree of contractionary or
    expansionary policy with any number of combinations of balance
    sheet adjustment and interest on reserve.
        Unwinding the Fed's balance sheet is contractionary, other
    things equal. But interest on reserves or raising the rate of
    interest rate, of interest on excess reserves, is also
    contractionary. If, right now, we have a combination where
    banks are encouraged to hold high excess reserves and the
    balance sheet is very large.
        Now, even if you think that the overall stance of policy is
    sound, that combination implements the stance of policy in a
    way that involves less productive investment. The alternative
    is for the Fed to have a smaller balance sheet and for interest
    on reserves to be lower so that the demand for excess reserves
    is lower.
        You can have the same monetary policy stance but end up
    with much more productive activity as a result of more savings
    being allocated through the private sector banks and fewer
    through the Fed.
        Mr. Stutzman. Absolutely. I agree with that and I just
    think that we have to focus on velocity in the economy and this
    is one thing that is slowing down our monetary policies. With
    that, Mr. Chairman, I will yield back.
        Mr. Mulvaney [presiding]. I thank the gentleman. I will now
    recognize the gentleman from Michigan, Mr. Kildee, for 5
    minutes.
        Mr. Kildee. Thank you, Mr. Chairman, and I thank all the
    witnesses for your participation.
        My question is specifically for Dr. Keister. First of all,
    welcome, and congratulations on a wonderful commencement
    exercise that you had at Rutgers. It got a lot of attention and
    we welcome, we certainly welcome Rutgers to the Big 10. As a
    Michigan fan, I have to tell you, any chance we can have
    somebody come in to sort of slip below our ranking, we are
    happy to have you.
        Mr. Keister. You are welcome.
        Mr. Kildee. Thank you, and I apologize if my question is
    redundant or has already been addressed. I was just able to get
    here to the hearing.
        But if I understand the hearing, it concerns the tools
    currently available to the Fed in order to influence short-term
    rates in particular, paying interest on excess reserves and
    overnight reverse repurchase operations so, Doctor, in your
    testimony before our committee in February, in her testimony,
    Chair Yellen indicated that higher rates of interest paid on
    excess reserves would, in her words, eventually pass through to
    customers in the form of higher deposit rates.
        My first question is, what evidence do we see that savers
    are actually benefitting from the increase in interest the Fed
    is paying on bank reserves in the form of higher deposit rates?
        And I ask this because I think it is important that we take
    a broader view regarding the resources that can be used to
    invest, particularly in distressed communities and cities,
    which have been the focus of a lot of my work.
        I have pushed that the Fed use all of its tools to meet the
    obligations regarding stable prices but most importantly, I
    think, particularly in the areas I represent, to maximize
    employment. So, how do you see the Fed's influence over short-
    term interest rates impacting its broader goals? If you could
    address those two questions, I would appreciate it.
        Mr. Keister. Sure. So first, regarding the evidence that
    consumers are benefitting from higher rates, the whole goal
    when the Fed raises interest rates, it raises the interest rate
    currently that it is paying on excess reserves and it drags up
    all market interest rates with it. I don't have specific data
    handy, but I do have anecdotal evidence.
        I pay attention to the interest rate I receive from my
    bank, and when the Feds raised the interest rate on excess
    reserves from 25 basis points to 50 basis points, the interest
    rate I received went up.
        As I mentioned I looked it up for preparing my testimony.
    It is currently 30 basis points. Okay. So, and as the Fed
    continues to raise, as the economy continues to recover, the
    Fed finds it appropriate to continue to raise the interest rate
    it pays on excess reserves.
        Banks will compete for deposits and as they do so, that
    will bid up the interest rate the depositors are receiving. So
    raising interest rate on excess reserve is designed to benefit
    savers and that will happen. Could you repeat your second
    question?
        Mr. Kildee. The second question is, what are the
    implications for the Fed's broader goals, particularly
    regarding increased employment? In other words, what are the
    externalities that you see in a broader economy resulting from
    this practice?
        Mr. Keister. Sure. So, the Fed is always, in normal times
    and now, trying to balance the competing goals of promoting
    full employment while keeping prices stable. Okay? And the
    decisions the committee makes on the interest rates are
    designed with those two goals in mind.
        So, as has been discussed here so far, one possibility of
    removing accommodation and that is, restraining the economy as
    it continues to improve, would be for the Fed to shrink its
    balance sheet.
        I think the Fed has chosen, and Chair Yellen has testified,
    that doing so by shrinking the balance sheet is a less
    conventional way of communicating the stance of monetary policy
    to markets.
        The more conventional way is to do it by raising interest
    rates, and so the committee has chosen, at least for the time
    being, to normalize monetary policy by first raising interest
    rates and then later, shrinking its interest rate back to,
    sorry, shrinking its balance sheet back to a more moderate
    size.
        And in doing so, I think it is making a judgment that is
    reasonable in my view, that before taking the untested path of
    shrinking its balance sheet, we would like to make sure the
    economy is on a more sound footing and to decrease the risk
    associated with any uncertainty or any market disruptions that
    could be potentially associated with that.
        Mr. Kildee. Thank you. My time is just about up. I yield
    back the balance of my time.
        Mr. Mulvaney. Thank you. The Chair will now recognize Mr.
    Schweikert from Arizona for 5 minutes.
        Mr. Schweikert. Thank you, Mr. Chairman. You look good in
    that chair. Okay. I have a dozen different questions and let us
    try to ramp through them and see if we can make them make
    sense.
        Mr. Keister, I remember a conversation about 2 years ago
    that the RRP's sort of mechanics that we were looking at,
    particularly in light of deposit insurance, sort of arbitrage
    that a bit, that actually you would, in some ways inflate up,
    long term mortgage rates, because you would be, in a sense. Was
    that what you were telling me about your own personal
    experience on a home loan?
        Mr. Keister. That is right. So if I understand correctly,
    you are asking so, as the Feds raised the interest rate on
    excess reserves, it also raised the interest on this new
    overnight RRP--
        Mr. Schweikert. Well, yes. It is obviously more than that.
    You have the IOER's, a pool, take away my deposit insurance,
    pull that out of the market, would you then start to raise up
    my cost of mortgage?
        Mr. Keister. That is right. So any time the Fed raises
    short-term interest rates, the goal is to be removing monetary
    accommodation and that should raise longer-term rates.
        Mr. Schweikert. Okay. Dr. Selgin, there are a couple of
    things I am trying to get my head around. First off, is this
    sort of system we have right now with the Feds dramatically
    sort of growing the way they are compensating excess reserves
    and sort of that reverse repo mechanic?
        Has it started to squeeze out private providers of repo?
    Because now I am competing with the Federal Reserve and I no
    longer have deposit insurance. Are we seeing that?
        Mr. Selgin. Yes. It is because of the way the Fed repo
    operations work. They actually don't, they take collateral from
    the marketplace that is not available even though technically
    you have short-term purchases.
        That is, the Fed is borrowing, but it is borrowing in a way
    that doesn't take the collateral off its balance sheet and make
    it available to the private sector.
        So, the result is that there is a shortage of collateral
    for other kinds of credit creation, including private repo
    operations. And this is a big problem.
        Mr. Schweikert. Dr. Eisenbeis, please.
        Mr. Eisenbeis. Actually, what the Fed is doing is repoing
    its own securities out into the marketplace. So, the securities
    actually become a liquid asset that can be repoed out, or used
    as collateral for other activities. So what is supplying
    liquidity in the market, in terms of--
        Mr. Selgin. Not true.
        Mr. Eisenbeis. --the securities.
        Mr. Selgin. No.
        Mr. Schweikert. But--
        Mr. Selgin. No.
        Mr. Schweikert. --even in that case, all you are doing is
    functionally saying, hey, I already hold the asset. That is my
    pledge on the repo. You are--
        Mr. Eisenbeis. What it is doing--
        Mr. Schweikert. --basically just pulling that cash out.
        Mr. Eisenbeis. What it is doing is sterilizing part of the
    excess reserves.
        Mr. Schweikert. Yes, but that doesn't leave you any
    multiplier effect in--
        Mr. Eisenbeis. No, it doesn't.
        Mr. Schweikert. --in the least light.
        Mr. Eisenbeis. No.
        Mr. Schweikert. And that was part of the, where I was going
    to go with. It is this, okay, fine. I get to use my existing
    book, I get to pledge it up, I get my repo.
        But if you are having an argument saying, okay, where is my
    liquidity, my expansive monetary policy, you are actually, in
    some ways, doing just the opposite.
        Mr. Eisenbeis. No, it is designed to raise interest rates.
    It is the tools that sort of tighten policy, in that sense.
        Mr. Selgin. They are, if I may say--
        Mr. Schweikert. No.
        Mr. Selgin. Sorry.
        Mr. Schweikert. Sorry.
        Mr. Selgin. The--
        Mr. Schweikert. And tell me if I was wrong in my--
        Mr. Selgin. No, you are not.
        Mr. Schweikert. --feeble attempt to explain.
        Mr. Selgin. You have to understand, there are two ways
    interest ways can be raised. Doctor Keister referred to
    tightening money, as a way of raising interest rates; which it
    certainly will do in the short run.
        But the overwhelming reason for low interest rates right
    now is the low level of GDP in overall nominal spending. And
    that has a contractionary effect and interest on reserves
    contributes to that.
        But if we avoid spending by creating more liquidity,
    instead of increasing the demand for liquidity, that too will
    eventually put upward pressure on interest rates, but in a way
    that doesn't involve overall tightening of--
        Mr. Schweikert. Okay.
        Mr. Selgin. --credit.
        Mr. Schweikert. This is one of those moments I definitely
    wish I had more time.
        Dr. Taylor, I need help on two things, and you have like 10
    seconds to do it. If I come to you and say, the size of the
    book as it is today on the Federal Reserve, what does that do
    to lending velocity in the overall economy, when my safe yield
    rate is, I basically, I have a free, or safe rate with a yield.
        So, my cash ends up going into the Federal Reserve, instead
    of multiplying in the economy. And next--no, let us do that
    because we are out of time. So--
        Mr. Taylor. I think in that case, these excess reserves
    are, if anything, signaling that they are going to be there for
    a while. So there is this notion they are going to there for a
    while, and therefore, we are not going to be back to normal for
    a while.
        And I think that is a problem with its effects on the
    economy. That is the main thing I would say about that.
        Mr. Schweikert. I couldn't find it, but somewhere I have an
    article about the allocation of capital argument. That one of
    the problems for our lack of growth is--
        Mr. Taylor. Yes.
        Mr. Schweikert. --we are not getting the allocation in--
        Mr. Taylor. I think in the--
        Mr. Schweikert. --places in the economy--
        Mr. Taylor. --Federal. Certainly in the money markets.
        Mr. Schweikert. --where, yes you might have a little risk;
    but you get a--
        Mr. Taylor. Yes.
        Mr. Schweikert. --multiplier.
        Mr. Taylor. That is it.
        Mr. Schweikert. Is this the--
        Mr. Taylor. That is a--
        Mr. Schweikert. --cost.
        Mr. Taylor. Certainly in the money markets they haven't
    been functioning very well at all. Maybe they will as the rates
    come up a little bit, but that is an allocation of those funds
    to different banks and different parts of the economy, which is
    not very effective, with the near zero interest rate.
        Mr. Schweikert. All right. Mr. Chairman, thank you for your
    patience. I yield back.
        Mr. Mulvaney. I now recognize the gentleman from New
    Mexico, Mr. Pearce.
        Mr. Pearce. Thank you, Mr. Chairman.
        If the gentleman from Arizona needs a little bit more time,
    I would be happy--I was going to follow right along in that
    line of questions if you--
        Mr. Schweikert. Maybe, keep going--
        Mr. Pearce. Okay. So, this idea that we are encouraging,
    Dr. Keister, this is kind of at odds with your testimony. But
    it is something that I believe in real life that we are giving
    incentive for banks to hold reserves, rather than getting the
    money out to where it starts causing the economy to grow.
        You appear to approach it from a little different point of
    view. Can you explain why that perception that you have been
    hearing is now, and is definitely rooted in my mind, is maybe
    incorrect?
        Mr. Keister. Sure. So, it is important to keep in mind that
    when the Federal Reserve creates reserves, as Dr. Eisenbeis
    mentioned earlier, they don't disappear. So the quantity of
    reserves in the banking system is going to be there. No matter
    how much lending goes on, and other activity. Okay?
        So when the Federal--and also when, as I testified earlier,
    when the Federal Reserve creates reserves, that process also
    creates bank deposits. So banks are getting a new source of
    funding, at the same time that they are getting a new asset.
        So, that funding, that new asset is not crowding out other
    things they--other assets they could be holding. Loans to
    businesses, loans to consumers.
        Mr. Pearce. Yes, see I would perceive it exactly the
    opposite, that a bank is sitting here with its reserves, and
    they have to tell us what to do with them. If they don't have
    that return on that investment, then they are sort of forced to
    do what banks are supposed to do.
        But I think now then, a lot of banks are just sitting on
    reserves. I don't think they are out there, because I hear the
    small business people coming and saying, well, I have pretty
    good credit. I have never missed a payment, but I can't get a
    loan. I want to expand my business. And so, the banks are being
    given an incentive to stay out of the business of loaning
    money, and so, yes, I didn't quite--
        Yes, sir, Dr. Selgin.
        Mr. Keister. Well--
        Mr. Pearce. Selgin. The other seat, go ahead. You seem to
    want to make comments, so I am going to--
        Mr. Selgin. Yes I do. Thank you. It is true that when the
    Fed creates reserves, it creates an equal amount of deposits in
    the system.
        But it is also true that in the absence of interest on
    reserves, conventionally and before the crisis, the total
    deposit creation, because of the lending of the extra reserves,
    that is of the excess; would end up being something like 10
    times the initial creation associated with the Fed's own
    expansion.
        So, what happens in the interest on reserves, on excess
    reserves environment, what has happened, is that multiple of 10
    has gone away. And this is why, as a ratio of their total
    balance sheets, the banks, end up holding a much higher than
    they normally do.
        It is the ratio that is determining the relative extent of
    productive investment that goes on. And that ratio of
    productive investment to reserves is what is down. Banks have
    control over that.
        If they didn't have control over the ratio, why in other
    cases where central banks have created vast amounts of
    reserves, you would see reserves--excess reserves accumulating,
    instead of banks lending more. Every hyper-inflation we have
    ever seen would have been impossible, because the banks would
    have just sat on their reserves.
        Mr. Pearce. Okay. Wait.
        Mr. Selgin. So it is not true that banks have no choice.
        Mr. Pearce. So, if we are going to follow on, and we want
    to add another variable into it. So now then, you get
    regulators. You consider that, okay. Maybe the interest has an
    effect, maybe it doesn't.
        But when you get regulators coming in, and looking at the
    bank, and saying, about fairly safe loans, that we are going to
    classify this loan. So now then, you have just the suggestion,
    says, I am better off being on the sidelines because the
    regulatory impact of very good loans--again, these are loans
    that I have heard about in our district, where people say, why
    would I ever lend money? When the regulators are going to say
    this, and they will pay me not to lend money.
        And so, in a State like New Mexico, with a small economy,
    we have 70 days' worth of funds to lend for houses. So, it is
    not like the State is swimming in cash reserves.
        And yet, we are giving these depressing effects. So we have
    not seen that dramatic economic growth that is being proclaimed
    here in Washington that is occurring.
        Dr. Taylor, do you have an observation?
        Mr. Taylor. Yes. I think during this period where they had
    a 25 basis points interest on reserve, it is really in
    retrospect I think. Dr. Selgin is correct about this. In
    retrospect, I would say, why did they do that?
        I think Dr. Kiester is saying, well, they were doing that
    because they wanted to move to ready to move it from 50 basis,
    from 25; which is not clear why they had to do that.
        So, I think, a lot of these questions wouldn't be there,
    had they just not paid interest rates on reserves. They had the
    right to do that, obviously. It doesn't mean they have to pay
    interest. They could have paid zero, starting back in 2008
    until now, until December of 2015.
        I think, in retrospect, it certainly would have been a
    better thing to do. They have given lots of answers to that to
    people over the time, I am sure. I think the main one is to be
    ready. The mechanism is there. I think it is questionable.
        Mr. Pearce. Yes, and then just then a last point that, and
    thanks, Mr. Chairman for a little bit of the time here, but the
    banks, a little bit, get out of the perfection of making good
    loans versus bad loans.
        And so, they are uncertain because their activity has
    shrunk down, due to regulatory things, and cash reserves are
    being really encouraged. And so, I find that the banks even get
    a little out of practice, in determining what is a good loan
    and a bad loan.
        And then, they are even more hesitant, at a time when we
    need them to be more courageous. They are more hesitant, and
    the economy suffers.
        Thank you, Mr. Chairman for your indulgence.
        Mr. Mulvaney. I thank the gentleman. And while we are not
    going to do a second round, Ms. Moore was very gracious in
    allowing me to maybe ask just a few more questions to finish up
    on some of our dialogue earlier, Dr. Selgin.
        To refresh your recollection, we were talking about the Fed
    not marking to market the balance sheet implications of the
    value of their assets, and so forth. And then you made a
    comment as the time was expiring about the P & L, the profit
    and loss impacts of that.
        And whether or not if their earnings, the net earnings,
    turned negative, they might have to come hat in hand to
    Congress. I had actually asked Dr. Bernanke that question along
    those lines 2 years ago.
        Where in a rising interest rate environment, you can
    foresee a situation where the net earnings of the Fed go
    negative. That they will have to end up paying off much higher
    rates of interest, they won't be earning as much on their
    balance sheet, et cetera.
        And I asked him, what would happen? And he did not say that
    they would have to come hat-in-hand to Congress to ask for
    money. He said they would simply take it off the balance sheet,
    or adjust the balance sheet.
        I never really understood exactly what he was talking
    about. I got the impression what he meant was, they were going
    to conjure the money up, the same way they do to buy. Dr.
    Eisenbeis is saying no.
        Dr. Selgin is looking at me, like, he is not sure what I am
    talking about. I am just curious to know, what might happen in
    a situation where the profit and loss turns negative for the
    Federal Reserve? We will start--
        Mr. Eisenbeis. I have--
        Mr. Mulvaney. --with Dr. Eisenbeis.
        Mr. Eisenbeis. I have the answer to that.
        Mr. Mulvaney. And then go to Dr. Selgin.
        Mr. Eisenbeis. I have the answer to that, sir. According to
    the way the law is set up, when the Fed income is no longer
    sufficient to pay interest on reserves, they stop making
    remittances, and write the difference up in this negative asset
    account that I was talking about before.
        And what that is, is an acclaim on future revenues on
    Treasury securities, and assets on the balance sheet that as it
    is received, would be used to write down that account, and when
    it can borrow from the--
        Mr. Mulvaney. To borrow from their own future earnings--
        Mr. Eisenbeis. Yes.
        Mr. Mulvaney. --is what I have--and something that private
    business can't do, right?
        Mr. Eisenbeis. No. Actually, there is the loss
    carryforward, but it is not really, totally analogous to this.
        Mr. Mulvaney. I have never been able to monetize a loss
    carry forward. I have news for you, it is hard to do, but--
        Mr. Eisenbeis. The Fed can do it, however. But it is
    really, sort of, an accounting gimmick. To sort of preserve,
    and enable the Fed not to have to go to the Treasury.
        Mr. Mulvaney. It is not that common because it has never
    happened, right? The Fed is never--
        Mr. Eisenbeis. No.
        Mr. Mulvaney. Okay.
        Dr. Selgin, are you, in general, accord with that?
        Mr. Selgin. Yes, you can do that up to a point. Remember
    that the interest payments that have to be made to the bank
    exceed the terms, then it is losing money. In that case, there
    has to be some monetization involved in order for--it has got
    to be covered somehow.
        Mr. Mulvaney. It does have to be covered somehow. But my
    understanding is that they can--they can monetize these future
    earnings to this negative asset account. And, essentially, they
    have to have cash. Because the cash has to go out the door.
        Mr. Selgin. That is it, that's right, there is monetization
    involved, and that is essential, and--
        Mr. Mulvaney. --and it is self-monetization, essentially
    conjuring the money up, correct?
        Mr. Selgin. That is right.
        Mr. Mulvaney. Dr. Keister?
        Mr. Keister. I would just like to add one point. So, this
    possibility we are discussing is the flip side of the larger
    emittances the Fed has been making to the Treasury over the
    past few years.
        The entire problem could be avoided if the Congress
    authorized the Fed to hold--to create a reserve fund to hold
    back some of these larger emittances, until it is able to
    shrink back its balance sheet, and this possibility has
    disappeared.
        Mr. Mulvaney. That is a fascinating idea. It sounds like a
    great way to solve the GSE problem.
        Dr. Eisenbeis, did you have one last thought on that?
        Mr. Eisenbeis. Yes. In fact, the opposite has happened
    because the Fed surplus in the Highway Transportation bill, $20
    billion of it was taken off the Fed's balance sheet.
        So, now they have only $30 billion in equity, combination
    of paid-in surplus and everything. So--
        Mr. Mulvaney. I think that was noted, wasn't it, on one of
    Ms. Moore's earlier graphs as an additional remittance during
    last year.
        So, if there are no further follow-ups on that specific
    topic? Ms. Moore, do you have anything else?
        Ms. Moore. No, it was a good question.
        Mr. Mulvaney. I appreciate the ability to ask that
    question.
        Mr. Eisenbeis. Mr. Chairman, may I make just another
    clarification? And it has to--
        Mr. Mulvaney. I will stay as long as Ms. Moore wants to.
        Mr. Eisenbeis. It relates to why the Federal funds,
    effective Federal funds rate was below the target. And the
    reason was because Freddie Mac and Fannie Mae were not able to
    hold and earn interest on their deposits at the Fed.
        So, they were accumulating large amounts of excess funds,
    and lending them out into the Federal funds market, willing to
    take a rate below the target rate because they had no other
    alternative.
        And that is the reason the effective funds rate was below
    the target.
        Mr. Mulvaney. Fascinating. Ms. Moore, do you have anything
    else to add?
        Ms. Moore. I thank all of the witnesses for your
    indulgence, and we learned a lot.
        Mr. Mulvaney. The Chair notes that some Members may have
    additional questions for this panel, which they may wish to
    submit in writing. Without objection, the hearing record will
    remain open for 5 legislative days for Members to submit
    written questions to these witnesses and to place their
    responses in the record. Also, without objection, Members will
    have 5 legislative days to submit extraneous materials to the
    Chair for inclusion in the record.
         Thank you. The hearing is adjourned.
        [Whereupon, at 12:03 p.m., the hearing was adjourned.]

                                A P P E N D I X

                                  May 17, 2016

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