The Fed’s Fiscal Folly
A guest post by Alexander William Salter
The Constitution vests Congress with the power of the purse. In the United States, decisions about how public resources are allocated are supposed to be made by elected legislators. Yet over the past decade and a half, the Federal Reserve has increasingly exercised powers that look less like monetary policy and more like fiscal policy. This includes paying nearly $200 billion annually in interest to banks holding reserves at the central bank, instead of paying remittances to the Treasury.
Because the Fed’s earnings normally flow back to the Treasury, changes in the size and composition of its balance sheet have direct fiscal consequences. Large interest payments on reserves or asset losses reduce those remittances and effectively increase the federal deficit.
The reason is the Fed’s adoption of what economists call a floor system. Under this framework, the central bank can allocate credit to specific sectors. The result is a system in which the Fed can prop up particular markets or institutions without the usual political checks that accompany fiscal decisions. That should concern anyone who cares about constitutional governance.
To see why, compare the current system to how the Fed used to conduct monetary policy. Before the 2007–08 financial crisis, the Fed operated a corridor system. Bank reserves (deposits commercial banks hold at the Fed) were relatively scarce. Banks frequently borrowed reserves from one another in overnight markets, and the interest rate on those transactions was the key policy rate the Fed tried to influence.
The Fed targeted that rate, called the fed funds rate, by adjusting the supply of reserves through open market operations. This usually meant buying or selling Treasury securities. Because reserves were scarce, changes in reserves supply pushed market rates up or down. Monetary policy worked primarily through markets rather than administrative decisions. The Fed’s balance sheet was correspondingly modest. In 2007, the central bank held roughly $900 billion in assets.
The 2007-8 crisis changed everything. In response to financial turmoil, the Fed launched emergency lending programs and massive asset purchases. The quantity of reserves in the banking system exploded. We have been living within an ample reserves system ever since. Today, reserves alone exceed $3 trillion, and the Fed’s balance sheet peaked near $9 trillion after the pandemic.
The Fed now conducts monetary policy primarily by adjusting the interest rate it pays banks. Because banks can earn a risk-free return simply by holding reserves at the Fed, they have little incentive to lend them in overnight markets at lower rates. The interest rate paid on reserves therefore becomes the effective floor under short-term interest rates. This is how the floor system got its name.
This seemingly minute technical change has enormous practical consequences. Under the floor system, the Fed can use asset purchases to direct real resources to specific entities or groups, such as housing finance through large purchases of mortgage-backed securities. In effect, it can channel public financial support to particular sectors without congressional appropriation.
When the Fed buys assets (Treasuries, mortgage-backed securities, etc.), it creates new reserves in the banking system. Under the old corridor framework, those reserves would have pushed interest rates downward and increased the broader money supply. But now the Fed can prevent monetary spillovers simply by paying interest on reserves. Banks are happy to hold the newly created reserves instead of lending them out.
This means that the Fed can dramatically expand its balance sheet while still maintaining its target interest rate. That capability removes a key constraint that previously limited the central bank’s interventions. Rather than keeping the economy broadly liquid, the Fed now allocates credit. It determines who gets what resources—a power it exercises without meaningful democratic oversight.
Fiscal policy, of course, is supposed to be Congress’s job. Decisions about allocating public resources—whether to support municipalities, subsidize particular industries, or transfer funds to financial institutions—are inherently political. They reflect judgments about public priorities. In a constitutional system, those decisions properly rest with elected representatives. Yet the floor system allows the Fed to undertake such interventions without meaningful Congressional oversight.
It also generates substantial fiscal transfers. Because the Fed pays interest on the trillions of dollars of reserves held by banks, it distributes enormous sums to financial institutions each year. In 2024, those payments approached $200 billion annually, reducing the Fed’s remittances to the Treasury and effectively shifting public resources from taxpayers to reserve holders. This figure will likely total between $110 and $135 billion for 2025 because the Fed has modestly lowered interest rates and reduced its balance sheet. But if it needs to fight an inflationary resurgence—and let’s remember dollar depreciation still exceeds the Fed’s 2 percent target—those payments could rise again.
Even more worryingly, we must question whether this framework rests on sound legal ground. When Congress authorized the Fed to pay interest on reserves in 2008, it included an important constraint: the rate paid on reserves was not supposed to exceed the general level of short-term interest rates. The goal was to eliminate an implicit tax on reserves, not to create a new operating framework for monetary policy.
Yet under the floor system, the interest-on-reserves rate has effectively become the Fed’s primary policy instrument. By redefining which market rates count as the relevant benchmark, the Fed has interpreted the statute in a way that allows it to pay a premium rate on reserves and anchor the entire interest-rate structure. Whether the Fed’s actions comport with the authorizing statute is, at best, debatable.
Even if the Fed’s interventions stabilized financial markets—something that is highly uncertain— that is no defense of the current operating system. The broader institutional shift remains troubling. The modern floor system blurs the line between monetary and fiscal actions. It allows the central bank to allocate credit, distribute large transfers, and expand its balance sheet to trillions of dollars without explicit direction from Congress. That should deeply trouble anyone who cares about the constitutional processes of self-government.
Congress must act to rein in the Fed. It should revise the 2008 statute authorizing interest on reserves to ensure the rate paid stays below market benchmarks. As an example, the statute could require the Fed to pay no more than a discount (say, 25 basis points) on short-term Treasury yields. Congress should also conduct stricter oversight of large Fed balance sheet expansions, for instance by implementing mandatory review for purchases above a certain size or if the Fed’s balance sheet exceeds a specified fraction of GDP. And it should work with the next Fed chair to shrink Fed asset holdings significantly. In particular, the Senate should make clear it will not confirm any presidential nominee for Fed chair without a clear commitment to return to the pre-2008 operating framework. Lastly, legislators ought to make it easier to fire top Fed decision-makers for violating any of these rules. These reforms would help to restore the institutional safeguards that once governed U.S. monetary policy.
In conclusion, we have stumbled into a situation in which unelected central bankers exercise powers with major fiscal consequences—affecting federal deficits, directing credit to favored sectors, and distributing large financial transfers—while legislators look the other way. In a system predicated on democratic accountability, decisions about allocating public resources should ultimately belong to Congress, not to central bankers acting on their own initiative.
Alexander William Salter is the Georgie G. Snyder Professor of Economics in the Rawls College of Business at Texas Tech University and a research fellow with TTU’s Free Market Institute. He is also a Senior Fellow with the American Institute for Economic Research’s Sound Money Project.
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