Federal Reserve Report Defends Use of New Tools to Set Interest Rates

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The Federal Reserve building in Washington.

The Federal Reserve building in Washington.


Photo:

Andrew Harnik/Associated Press

WASHINGTON—The Federal Reserve defended having the flexibility to set interest rates by using relatively new tools that include paying interest to banks in its semiannual report to Congress on Friday.

Fed Chairman

Jerome Powell

is scheduled to testify on Capitol Hill over two days beginning Tuesday in the Senate as part of hearings mandated by law. The Fed released its report ahead of those hearings.

Some lawmakers, particularly in the House of Representatives, have criticized the Fed in recent years for the use of new facilities that enabled the central bank to guide short-term interest rates higher while maintaining a much larger portfolio of bonds and other assets than existed before the 2008 financial crisis.

Those criticisms reflect in part broader concern on the part of those lawmakers with the emergency steps the Fed undertook from 2008 through 2014 to stimulate growth after the central bank cut interest rates to near zero.

The report released Friday included a three-page overview of its new tools that could serve as a pre-emptive rebuttal against any further concerns lawmakers might raise next week.

The Fed dramatically expanded its bond portfolio after the 2008 financial crisis as it unleashed successive campaigns to stimulate the economy by purchasing Treasury and mortgage securities. Those purchases swelled the amount of deposits, known as reserves, that banks maintain in accounts at the Fed.

The vast increase in reserves, which rose to more than $2.5 trillion in 2014 from about $15 billion in 2007, made it harder for the Fed to change interest rates by buying or selling securities in the open market, as it had before 2008.

In order to raise its benchmark federal-funds rate without first draining its bondholdings and the accompanying bank reserves, the central bank implemented new tools to guide the fed-funds rate in a certain range, including by paying interest on those reserves.

Without the new tools, the Fed “would not have been able to gradually raise the federal-funds rate” while maintaining a larger portfolio, the report said. Instead, it would have had to consider “a rapid and sizable reduction” the bond portfolio to push up borrowing costs.

“Getting the pace of asset sales just right for achieving the Federal Reserve’s objectives would have been extremely challenging. Such an approach…would have run the risk of disrupting financial markets” and hurting economic growth, the report said.

Last fall, the Fed began gradually shrinking its bond portfolio by not replacing some bonds when they mature. That is also draining the amount of reserves in the system. The Fed hasn’t decided how long the runoff will last because it doesn’t know the optimal level of reserves going forward.

The size of the Fed’s holdings is likely to be “much lower than it is today, though appreciably higher than it was before the crisis,” in part because new liquidity requirements have made banks more eager to own those reserves.

The defense of the new tools is notable because officials, while not having formally decided on how to set interest rates over the long run, appear to prefer maintaining the current system, according to recent interviews and public statements. This would require a larger portfolio of both Treasury securities and bank reserves—and the continued payments of interest on those reserves.

The report didn’t elaborate on whether or how those discussions around the longer-run rate-setting framework have proceeded. Nor did the broader 63-page report provide new clues about the immediate policy or economic outlook.

The report continued to describe valuations for a range of financial assets, including stocks and real estate, as “elevated” but said financial vulnerabilities associated with borrowing “remain moderate on balance.”

The economy has largely performed in line with Fed expectations this year, though officials face puzzles determining how changes in fiscal and trade policy might influence their forecasts for growth and inflation.

For now, strong economic growth, low unemployment and stable price pressures have made it easier for Fed officials to agree on a policy of gradually lifting rates to a level they consider neutral, meaning they will seek to neither spur nor slow growth. While estimates of the so-called neutral interest rate vary, most officials believe the rate is around 2.75% or 3%.

The Fed has raised its benchmark short-term rate twice this year, most recently in June to a range between 1.75% and 2%, and officials last month penciled in two more rate increases this year and three more next year. That path means the Fed could reach its estimated neutral rate by next spring or summer.

The Fed’s mandate from Congress is to maximize sustainable employment and ensure prices are stable, which the central bank defines as meeting a 2% inflation target.

The Fed is closer to meeting those goals than at any point in the past decade. The unemployment rate, at 4% in June, has for the past few months been below the level all Fed officials believe is likely to prevail over the long run.

Consumer prices in May rose 2.3% from a year earlier, and excluding volatile food and energy categories, rose 2%, according to the Fed’s preferred inflation gauge.

Write to Nick Timiraos at nick.timiraos@wsj.com

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