On the heels of a prominent monetary policy conference last week, Friday saw a flurry of news stories (for starters, here and here) noting the political fallout that could ensue once the Federal Reserve begins to unwind the unconventional policies it put in place during and after the Great Recession. Because the Fed could incur losses when it eventually raises interest rates and sells off assets from its ballooned balance sheet, many expect that by the end of the decade the Fed might no longer generate sufficient earnings to return profits to the Treasury. After a decade of rising profits remitted to Treasury (topping out at nearly $89 billion last year), many wonder whether Fed losses could trigger aggressive push back from Congress.
Questions about how legislators might respond to future Fed losses are worth pondering, not least because Chairman Ben Bernanke heads to Capitol Hill this week to deliver his semiannual report on monetary policy. A few thoughts, after a brief historical detour.
Contrary to most news coverage, the Federal Reserve Act (FRA) does not require the Fed to remit profits to Treasury. Congress imposed a franchise tax on the Fed in the original FRA in 1913—requiring the Fed to remit 100 percent of its earnings after paying expenses and dividends, lowering the tax in 1919 to ninety percent. But Congress stopped taxing the Fed in 1933, swapping the franchise tax for a one-time Fed payment to help capitalize the newly-created Federal Deposit Insurance Corporation. Only after the Fed became profitable in the wake of World War 2 did Congress did consider re-instating the franchise tax. In response, the Fed pre-empted Congress in 1947 by reinterpreting an obsolete anti-inflationary provision of the FRA that had been designed to empower the Fed to charge interest on its reserve banks’ holdings of Federal Reserve currency. The Fed simply choose a rate that generated revenue equal to what would have been collected by a franchise tax and then remitted most of that revenue to Treasury. Today, an internal Fed policy still guides remittances, absent a statutory mandate.
The Fed seemed to have several motivations for moving independently of Congress in 1947 to formalize a remittance policy. First, the Fed sought to pre-empt congressional critics angling to reinstate the franchise tax. Moving first allowed the Fed to protect its independence and flexibility over the level of profits returned to Treasury. Second, beating Congress to the punch empowered the Fed in its efforts to negotiate with Treasury an increase in the fixed interest rate that the Fed paid on government debt during wartime. As FOMC meeting notes from 1946 hint, by promising to send profits to Treasury, the Fed would subsidize the increased borrowing costs faced by Treasury once the Fed raised rates. By promising remittances and avoiding a statutory mandate, the Fed’s solution preserved the Fed’s flexibility and independence over monetary policy. In fact, some years later the Fed exploited its flexibility to increase the level of profits returned to Treasury.
Why care about the history of Fed remittances? With caveats given the differences between then and now, the 1947 episode offers a glimpse of potential legislative landmines should Fed profits turn to losses.
First, the Fed still prizes its independence and would oppose any congressional efforts to reinstate the franchise tax. Even if there is no practical difference between the Fed’s internal policy and a mandated franchise tax, the Fed would no doubt oppose a statutory mandate to hand over future profits on the grounds that such a mandate would infringe on the Fed’s conduct of monetary policy. Still, historical precedent for the franchise tax might undermine the Fed’s persuasiveness.
Second, Congress likely cares about Fed profits and will question underlying policies if they generate losses—even if such losses ensue from an exit strategy designed to stem inflation. Congressional Republicans, who never liked the Fed’s asset purchases in the first place, could use potential losses to hammer the Fed’s conduct of monetary policy. Democrats, counting on the Fed to secure its statutory mandate of maximum employment, could accuse the Fed of prematurely unwinding its unconventional policies. In sum, both parties could exploit potential losses to criticize the Fed’s policy choices. If the economy had indeed strengthened, then perhaps lawmakers would give the Fed a pass: Congress tends to ignore the Fed when the economy is in good shape. More likely, Congress would pounce. Even if a franchise tax were to be off the table, Fed losses could re-fuel the audit-the-Fed movement, on the grounds that Congress needs to know more about the details of the Fed’s exit strategy. Already today, half of the Senate Republicans have signed onto Senator Rand Paul’s audit the Fed bill. (Like father, like son.) Continued polarization reduces the chances of congressional action. But imposing more transparency on the Fed might have bipartisan appeal.
Ultimately, much uncertainty pervades projections about potential Fed losses in coming years, as suggested recently by Fed economists. And overall, economic growth stemming from the Fed’s unconventional policies would presumably increase tax revenues flowing into Treasury’s coffers, offsetting losses from the Fed. Still, as one former Fed governor said at Friday’s conference, “Politicians have very short memories…They’re going to focus very much on the fact that the Fed is no longer pulling its weight in terms of producing remittances for the federal government.” If Fed profits plummet, lawmakers’ myopic eyesight reduces the chances that Congress will see the big picture.