A question on paying interest on excess reserves came up during Janet Yellen’s recent congressional testimony.

Bloomberg writer Peter Coy offered this Q&A on a Fed Practice that Mystifies Congressmen. However, Coy blew many of the answers.

Coy: Federal Reserve Chair Janet Yellen ran into a bipartisan buzzsaw today over why the Federal Reserve is paying interest to banks on the trillions of dollars in reserves that they hold at the Fed. She tried repeatedly to supply the central bank’s reasoning but didn’t seem to make a dent.Here’s an explanation of the Fed’s position, which didn’t exactly come through in the sound bites under the bright lights of a congressional hearing.

“Please, please explain,” Representative Maxine Waters (D-Calif.), the ranking Democrat on the House Financial Services Committee, said at one point. Committee Chairman Jeb Hensarling (R-Texas) said the Fed’s interest-paying policy “can distort resource allocation and constrain economic opportunity.”

Coy: Here’s an explanation of the Fed’s position, which didn’t exactly come through in the sound bites under the bright lights of a congressional hearing.

Q: What are excess reserves?
Coy: Excess reserves are ones that banks hold in excess of the ones the Fed requires (obviously). At last count, a little more than 93 percent of bank reserves were excess. In January, excess reserves totaled about $2.3 trillion.
Mish: No problem with that answer.

Q: Why so much “excess”?
Coy: During and after the financial crisis, the Fed bought trillions of dollars in Treasuries and mortgage-backed securities. It didn’t pay for them with wads of bills. Instead, it simply credited the sellers of the securities with bigger reserves at the Fed. So now banks have way more reserves than they could possibly use.
Mish: Essentially correct

Q: And that’s a problem?
Coy: Yes, because the Fed can’t conduct monetary policy the traditional way. In the past, if the Fed wanted to push up interest rates, it would sell a bunch of Treasuries. Banks would pay for the Treasuries by using money in their reserve accounts. That would leave them short on required reserves. To replenish their reserves they would borrow reserves from other banks at a well-known interest rate: the federal funds rate. That won’t work any more because the banks have so much in excess reserves that any Treasury purchases they made wouldn’t make a dent in the total.
Mish: Sort of. The Fed could have and should have acted to shrink its balance sheet before it hiked rates in December. Instead, the Fed kept its balance sheet over $2 trillion. Next the Fed waited too long to hike as we have seen, but that is a different issue.