Federal Reserve Chairman Jerome Powell is set to testify in the House and Senate this week. The semiannual two-fer testimonies are known as the Humphrey-Hawkins testimony, and this week’s is paired with the July version of the Fed’s official Monetary Policy Report. The report includes all sorts of fodder for members of Congress to question the chairman, but the ripest topic is the report’s defense of the Fed’s “interest on excess reserve” (IOER) policy.

I’ve written a decent amount on what’s wrong with IOER and the Fed’s new policy framework, but nobody has done more than Cato’s George Selgin. His take on the Fed’s newest defense of IOER is here, at Cato’s Alt-M blog.

George and I have often made similar complaints about IOER, and it is going to happen again in this column. First, though, I want to say something about the Fed and its targeting of the federal funds rate that George did not cover in his latest post.

Section 2 of the Fed’s report on Monetary Policy begins as follows:

Since December 2015, the Federal Open Market Committee (FOMC) has been gradually increasing its target range for the federal funds rate as the economy has continued to make progress toward the Committee’s congressionally mandated objectives of maximum employment and price stability….

The Committee expects that a gradual approach to increasing the target range for the federal funds rate will be consistent with a sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective over the medium term.

This passage makes it sound like the Fed hasn’t changed its operating framework since the 2008 financial crisis. Yet the Fed’s post-2008 operating framework (the leaky floor with IOER) differs radically from its pre-crisis set up.

In that earlier system, the Fed influenced interest rates with routine, small-scale, open market operations—the buying and selling of Treasury securities. The open market security purchases would add reserves to the banking system; security sales would take reserves away. Changing the supply of reserves influenced the federal funds rate, the rate that banks charged to lend each other reserves.

Changes in the federal funds rate were, in turn, expected to influence other short-term rates in the economy, thus allowing the Fed to “manage” the business cycle. As explained (by the St. Louis Fed) back in those pre-crisis times:

…the FOMC establishes a target for the federal funds rate (the rate banks charge each other for overnight loans). Banks take overnight loans to ensure that they have the necessary funds to meet the reserve requirements of the Federal Reserve System. The federal funds rate is important because movements in the rate influence other interest rates in the economy. For example, if the federal funds rate rises, the prime rate, home loan rates, and car loan rates will likely rise as well.

Similar explanations have been made by the San Francisco Fed, the New York Fed, and the Federal Reserve Board of Governors.

The official line has, in short, always been that the federal funds rate mattered because it was the interbank lending rate and, as such, was a crucial determinant of other interest rates.

But in the Fed’s post-crisis system, the federal funds rate cannot possibly have such a high level of importance. Largely because of the Fed’s own policies, lending volume in the federal funds market remains near a 40-year low. Furthermore, what little activity there is in the fed funds market is entirely different from the reserve-meeting activity that used to take place. According to researchers at the Cleveland Federal Reserve:

Because domestic depository institutions can receive IOER and the effective federal funds rate is below the IOER rate, they have largely ceased lending in the overnight market. This role is now mainly played by the GSEs, especially the FHLBs [the GSEs are not eligible for IOER]. On the borrowing side, domestic institutions are awash with reserves from the Fed’s asset purchases, and the FDIC’s new capital requirements penalize them for holding reserves. On the other hand, foreign institutions, many of which have reserve accounts with the Fed, are not under the FDIC’s regulatory umbrella. A foreign bank with an interest-bearing reserve account can borrow from the FHLBs at the federal funds rate, store the cash in its reserve account, and earn IOER minus the rate paid on the federal funds.

So here’s a great question (the first of four) a member of Congress could ask the Fed Chair this week:

1. Why is the Fed still worried about targeting the federal funds rate even though the interbank lending market is essentially dead?

A pair of more philosophical questions for the Chairman would be:

1. How can the Federal Reserve still be having so much influence over interest rates if inter-bank lending of reserves, which was the key to the whole system, has all but disappeared?
2. Does the Fed have more influence over interest rates now that its main policy tool consists of paying banks to sit on their reserves?

Regardless of the answers to these questions, the Fed is now paying large financial institutions billions of dollars per year because of the new operating system it developed. And the Fed’s defense of that system in the new Monetary Policy Report is so twisted it makes one wonder why the central bank is so tied to any policy that it would go to such lengths to defend it.

Page 44 of the report champions the new operating framework in a breakout box titled “Interest on Reserves and Its Importance for Monetary Policy.” The section begins as follows:

The financial crisis that began in 2007 triggered the deepest recession in the United States since the Great Depression. In response, the Federal Open Market Committee (FOMC) cut its target for the federal funds rate to nearly zero by late 2008. Other short-term interest rates declined roughly in line with the federal funds rate. Additional monetary stimulus was necessary to address the significant economic downturn and the associated downward pressure on inflation.

The main problem is that the official record (and former Fed Chair Ben Bernanke’s own account) shows that the Fed was actually worried about upward pressure on inflation, that it actually followed rates down after they collapsed (see Chart 3), and that it implemented IOER specifically as a contractionary policy.

IOER simply was not an expansionary move. In fact, the Fed’s own contractionary IOER policy was a main reason the “Additional monetary stimulus was necessary.”

Perhaps the most maddening passage in this section of the report is this one:

The rate of interest the Federal Reserve pays on banks’ reserve balances is far lower than the rate that banks can earn on alternative safe assets, including most U.S. government or agency securities, municipal securities, and loans to businesses and consumers. Indeed, the bank prime rate—the base rate that banks use for loans to many of their customers—is currently around 300 basis points above the level of interest on reserves.

It is Congress’ duty to address this falsehood during this week’s hearings.

First of all, no economist or financial industry professional would categorize “loans to businesses and consumers” (presumably the “bank prime rate”) with other “safe assets” such as US Treasuries or bank reserves held at the Fed. It makes no sense to compare the IOER rate to the prime rate in this context. None.

Furthermore, the IOER rate has not been lower than rates on alternative safe assets. Indeed, for nearly the entire time the Fed’s IOER policy has existed, the IOER rate has been higher than virtually all other similar safe assets. (One has to use the term “similar” carefully because most other safe asset rates are not overnight rates for deposits held at the central bank.)

For evidence, check out Chart 6 of this paper and the graph in Selgin’s new post. Even now, the IOER rate is nearly equal to the 3-month Treasury Bill rate.

Making matters worse, the previous passage includes the following footnote:

The Congress’s authorization allows the Federal Reserve to pay interest on deposits maintained by depository institutions at a rate not to exceed the “general level of short-term interest rates.” The Federal Reserve Board’s Regulation D defines short-term interest rates for the purposes of this authority as “rates on obligations with maturities of no more than one year, such as the primary credit rate and rates on term federal funds, term repurchase agreements, commercial paper, term Eurodollar deposits, and other similar instruments.”

Perhaps Congress should not have authorized the Fed to create its own definition of “general level of short-term interest rates” back in 2006, but at the time Congress could hardly have expected such an outcome. The most egregious part of the Fed’s definition is that it includes the primary credit rate. This rate, also known as the Fed’s discount rate, is not a market rate at all.

The Fed literally sets this rate “above the usual level of short-term market interest rates.”

Even if Congress turns a blind eye toward this part of the Fed’s definition, the IOER rate has still been set above, if not far above, most reasonably comparable short-term rates for nearly the entire existence of the IOER framework.

Ten years since the crisis, the Fed is still operating under a framework that it started because of its contractionary nature, and it is still paying above-market interest rates to large financial institutions to keep a lid on inflation.

And, of course, all of this is going on in the context of the Fed trying to normalize its operations, requiring the Fed to shrink its balance sheet by selling some of the securities it purchased during the crisis/QE programs. Selling assets is, of course, also contractionary by nature.

So here is a fourth question for Chairman Powell:

1. Does the Fed’s current framework run a heightened risk of over-tightening, thus causing an economic downturn?

Truly normalizing monetary policy means undoing all of the changes instituted to respond to the abnormal crisis. To do so without creating a recession, the Fed has to shrink its balance sheet and stop paying banks not to lend. So far, there’s very little evidence that the Fed is moving in this direction.