February 10, 2016 / 8:01 PM / 2 years ago

Yellen draws fire for Fed policy to pay banks

* Rate paid to banks on excess reserves seen as subsidy

* Waters, Hensarling approved tool back in 2006

By Ann Saphir

SAN FRANCISCO, Feb 10 (Reuters) - Interest payments that Federal Reserve Chair Janet Yellen calls “critical” to the U.S. central bank’s conduct of monetary policy came under fire on Wednesday from lawmakers, raising questions about new potential political hurdles ahead for the Fed.

In an unusual display of bipartisanship, Jeb Hensarling, the Republican who chairs the House Financial Services Committee, and Maxine Waters, the top Democrat on the panel, both queried Yellen about the interest the Fed pays on excess bank reserves, with Hensarling calling it a “subsidy” to Wall Street and Waters imploring Yellen to find a way to raise rates without relying so heavily on “paying money to banks.”

The questions were among the first to follow Yellen’s semiannual Congressional testimony in which she flagged risks to the U.S. recovery but also reiterated her expectation that the Fed will continue to raise rates gradually.

Lawmakers’ concerns about the payments to banks follow criticism of the Fed by presidential candidates, with Republican Donald Trump blaming the central bank for creating an economic bubble and Democrat Bernie Sanders threatening to restructure the institution.

The Fed pays interest to banks on the trillions of excess dollars they keep at the central bank as a result of the Fed’s post-crisis bond-buying stimulus programs. When policymakers raised borrowing costs in December for the first time since the crisis, they did so in part by increasing the rate of interest paid to banks.

Yellen sought to explain that the Fed makes a lot more money on interest it earns on its massive portfolio than it pays out in interest to banks, and that it sent nearly $100 billion to the Treasury in 2015 as a result.

She warned that without the ability to pay interest to banks on their reserves, “we will be forced to greatly shrink our balance sheet in a rapid fashion...(which) would have very adverse effects on the economy.”

The ability to increase the Fed’s rate of payment on excess reserves, she said, means the Fed can tighten monetary policy while keeping its $4.5 trillion balance intact, Yellen said.

“It was not at all clear that these explanations were satisfactory for the questioning members of Congress,” JP Morgan economist Michael Feroli wrote in a note to investors. “(G)iven the bipartisan hostility to interest on reserves it bears thinking how this would play out.”

The Fed won the right to pay interest to banks on excess reserves in 2006 through a bill approved unanimously by members of the House, including Hensarling and Waters. Many central banks globally also pay interest to banks on their excess reserves. (Reporting by Ann Saphir; Editing by Andrew Hay)

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