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The Wilder View

Why exactly does the Fed pay interest on reserves?

The Fed’s paying interest on reserve balances has been bugging me lately. I simply don’t understand why the Fed would initiate a policy shift desinged to “improve efficiency in the banking sector” when the banking sector is in the middle of a crisis. To me, all the policy shift has done is to pay banks not to lend.

Here is what Vice Chairman of the Federal Open Market Committee (FOMC) Donald Kohn had to say about bank lending: “In recent weeks, bank lending appears to have dropped back, consistent with the significant tightening of terms and standards reported by bank loan officers in recent quarters as well as the weakening of economic activity.”

When in fact, what he really meant to say wass this: “In recent weeks, bank lending appears to have dropped back, consistent with the significant tightening of terms and standards reported by bank loan officers in recent quarters, as well as the the weakening of economic activity, and since banks are now earning interest on reserve balances.

Apparently, the Fed deemed it urgent to pay interest on reserves (IOR) because they fast-tracked the authorization for IOR that was initially set to start in 2011. As part of the Economic Stabilization Act of 2008, the Fed was granted authorization to pay IOR three years early. Theoretically, IOR improves the Fed’s ability to conduce efficient monetary policy in a world where required reserves are falling (see this paper for a nice discussion of monetary policy without reserve requirements). The Bank of Canada, the Bank of England, and the Reserve Bank of New Zealand all conduct monetary policy without reserve requirements, so why not the Fed?

The Fed said that the IOR policy would help “eliminate the opportunity cost of holding required reserves, promoting efficiency in the banking sector”. But why would a central bank try to improve efficiency smack dab in the middle of a banking crisis?

The most likey reason is that the Fed saw the IOR policy as an easy way to keep the effective federal funds rate close to its target as numerous $ billions in liquidity were added to the banking system. Well, that didn’t work. I bet that the Fed did not intend for excess reserve balances to balloon as they have.

reserve_chart.png

The chart illustrates total and excess reserve balances as a share of total bank credit (on the H.4.1 statement). The Fed’s added liquidity (added bank credit) – $1.3 trillion over the last yearpromote bank lending – has ended right back at the Fed’s doorstep in the form excess reserves. Banks are hoarding the funds and getting paid to do it!

But don’t worry, the IOR policy can simply disappear. If the Fed cuts to zero, which I believe is a very distinct possibility in January (or even December, who knows), the interest rate paid on reserves will also fall to zero (equal to the FOMC target). Headache gone; then we will see what happens to excess reserve balances.

But now that I think of it, the Fed can always change its mind…and the formula used to calculate the IOR rate for the third time.


Originally published at the News N Economics blog and reproduced here with the author’s permission.

2 Responses to “Why exactly does the Fed pay interest on reserves?”

AnonymousDecember 12th, 2008 at 2:36 am

In a situation where IOR policy disappears, and banks find that keeping liquidity in the form of excess reserves as inefficient, where do you think all this money will flow?

JamesJanuary 3rd, 2009 at 8:48 pm

I cited your post here on Wikipedia and have been in correspondence with the people in the Fed’s Federal Register notice, my congresswoman, and the CBO’s Long-Term Projections group about this.

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