Until very recently, the Federal Reserve had been ratcheting up bank regulations. Economists generally agree that excessive bank regulation dissuades banks from extending credit for some productive projects. In a recent speech, Fed Governor Stephen Miran points to another problem with excessive regulation. In brief, “regulations enacted to shore up financial stability have constrained the Fed’s control over some elements of monetary policy transmission and the size of the balance sheet.” He refers to such a situation as regulatory dominance, since monetary policy takes a back seat to the regulatory framework.
Miran has a point. But the problem is even bigger than he suggests. The entire post-2008 system of monetary control is not just misguided, but likely illegal. Congress has known this for seventeen years, and has not done a thing about it. Without concerted action by legislators, monetary policy will remain activist and the balance sheet bloated.
Bending the Rules
When Congress expanded the Fed’s authority to pay interest on reserves in October 2008, the law was clear. Section 19(b)(12) of the Federal Reserve Act said the interest rate the Fed pays on reserves cannot “exceed the general level of short-term interest rates.” This wasn’t some throwaway line. Congress meant what it said: interest on reserves was supposed to eliminate the implicit tax that had previously existed on reserve balances. It was not supposed to subsidize reserve holding, let alone revolutionize the monetary policy operating framework.
But the Fed had bigger plans. Facing an explosion of emergency lending, officials decided to pay banks more than comparable market rates, such as Treasury yields. This kept banks from lending out their excess reserves, which would have caused inflation.
As George Selgin documented in his book Floored!, the Fed’s creative solution was to reinterpret the statute. Officials decided that “rates on obligations with maturities of no more than one year,” including the primary credit rate, counted as short-term interest rates. The primary credit rate is an administered rate set by the Fed. In other words, the Fed is following the letter of the law (if not the spirit) provided the rate it pays on reserves is less than the rate it charges on loans.
Ignore the fact that obligations with maturities of not more than one year may have greater duration risk (and hence, should generally command a higher interest rate) than an overnight loan, which is effectively what the Fed gets when it pays interest on reserves. The Fed can set its primary credit rate as high as it wants! Again, it is an administered rate, not a market rate. If the primary credit rate determines the upper bound on the interest rate the Fed can pay on reserves and the Fed can set the primary credit rate as high as it wants, then there is no binding constraint on the rate the Fed can pay on reserves. That’s a clear subversion of Congressional intent.
As Milton Friedman remarked, “Nothing is as permanent as a temporary government program.” What started as an emergency measure has lasted nearly two decades. Paying a premium rate of interest on reserves fundamentally changed American monetary policy. Instead of carefully managing scarce reserves through open market operations, the Fed now floods the system with reserves and controls rates by paying banks to keep them idle.
To put it bluntly: to prevent emergency lending from depreciating the dollar, the Fed broke the law by deliberately paying a premium rate on reserves. It ignored Congress’s judgment and substituted its own.
Back to Miran
As Miran explains, excessive regulations boost demand for reserves. Banks worried about heightened scrutiny “can raise demand for bank reserves above and beyond what’s required” in order to assure bank regulators that the bank is safe and sound. Those reserves are necessarily supplied by the Fed. Our central bank currently holds a $6.6 trillion balance sheet and pays roughly $200 billion annually to banks — with megabanks and foreign institutions reaping the lion’s share.
But here’s what Miran gets wrong: regulatory reform treats the symptom, not the disease. Even with lighter regulations, the Fed would still be operating in a floor system, where it pays banks a premium to hold reserves. And that framework may have no legal basis whatsoever.
Congress Shrugs
The floor system isn’t a secret. The Fed operates it openly. Economists regularly debate its merits. Miran just gave a whole speech about its implications. Yet Congress has done nothing. It has neither authorized nor prohibited the Fed’s activities. All the public has gotten is occasional pointed questions at hearings, followed by studied inaction.
Miran himself notes that “several times now, the Senate has debated whether the Fed ought to be stripped of its statutory authority to pay [interest on reserve balances].” Sadly, this is concern without consequence. Congress’s oversight failure borders on dereliction of duty. If Congress thinks the floor system is good policy, write it into law. Remove the “not to exceed” language. Give the Fed explicit authority to use interest on reserves as its main policy tool.
If, on the other hand, Congress thinks the Fed exceeded its authority, do something about it. Restore the statutory limit. Require a return to traditional open market operations. Make clear that emergency measures don’t automatically become permanent powers.
This matters for more than legal niceties. If we’re serious about constitutional government and the rule of law, Congress can’t just shrug when agencies rewrite their mandates. The Fed isn’t special. The complexity of monetary policy doesn’t exempt it from following the law. And seventeen years of “everybody knows” doesn’t make an illegal system legal.
Conclusion
Miran is right to worry about regulatory dominance of the Fed’s balance sheet. But the real problem isn’t regulations forcing banks to demand more reserves — it’s that the entire system enabling those dynamics was never supposed to exist. Regulatory reform is certainly warranted. But it won’t fix the fundamental problem. We need legal fixes to target monetary policy directly.
Congress must explicitly authorize what the Fed has been doing, or require it to stop. Anything less is an abdication of its constitutional responsibility — and a betrayal of the principle that in America, no institution is above the law.
