There is a renewed debate regarding the merits of allowing the Federal Reserve to pay interest on excess reserves.
Recently, there has been a renewed debate regarding the merits of allowing the Federal Reserve to pay interest on excess reserves (IOER), with some suggesting that the interest payments amount to a giveaway to banks. In reality, the payment of IOER is a standard monetary policy tool used by all the major central banks. IOER is an especially critical tool for conducting policy at the current juncture because the Federal Reserve’s balance sheet is elevated in the wake of the large-scale asset purchase programs the Fed executed during the recession to push down longer-term interest rates and stimulate growth.
Managing the Federal Reserve’s Balance Sheet
Reserve balances are a liability of the Federal Reserve. The Fed controls the supply of reserves nearly exactly by adjusting the amount of assets it holds.
The Federal Reserve conducts monetary policy by setting the supply of reserves to deliver a desired level of the federal funds rate, and establishing a lending and deposit rate to put a ceiling and floor on the federal funds rate. Interest on excess reserves (IOER) puts a floor on the federal funds rate, because no bank should be willing to lend reserves for less than it could get simply leaving the reserves on deposit at the Federal Reserve Bank.
With reserve balances currently very elevated because of the Fed’s asset purchases, it plans on tightening monetary policy by raising IOER. In December 2015, the FOMC tightened policy slightly, raising IOER by 25 basis points. Money market rates have all essentially risen in lockstep.
The Fed Conducted Monetary Policy Without IOER Before, Why Can’t It Again?
It is true that historically, the Fed conducted monetary policy without IOER, but that was in a normal interest rate environment and at a time when the Fed’s balance sheet was drastically smaller. Under current circumstances, with reserve balances so large, the Federal Reserve could not tighten monetary policy without paying interest on reserves. Overnight interest rates would stay near zero. While the Federal Reserve could sell its holdings of longer-term securities to push up longer-term interest rates and drain reserves, the Fed would not be able to control longer-term rates with much precision. Longer term rates, including household mortgage rates, could jump up sharply, leading to an unwanted slowdown in economic growth.
The Payment of Interest on Reserves is not a Net Loss to Taxpayers
The large volume of reserves reflects the large volume of Fed assets. The Fed has earned interest on those assets and remitted the proceeds to Treasury. Annual Fed remittances to Treasury between 2010-2015 have averaged about $90 billion, up from $30 billion before the crisis.
The Fed projects that its net interest income will remain substantial, even as interest rates rise. By contrast, if the Fed did not have the ability to pay IOER and instead had to sell its holdings of securities to tighten monetary policy, it could make capital losses, reducing remittances to taxpayers. Moreover, the costs of paying interest on reserves pales in comparison to the potential cost to U.S. households, businesses, and government of the less precise monetary policy that would result with no IOER.
The Payment of Interest on Reserves is Not a Windfall for Banks
Banks have to fund their holdings of reserve balances, not only with deposits and debt, but also with equity. Reserve balances, even with IOER, are relatively low-yielding assets. The large quantity of reserve balances pushes down bank earnings. Banks’ net interest margins are currently at very low levels. When monetary policy and financial conditions normalize, banks will receive an interest rate on their deposits with the Federal Reserve that is approximately equal to, or below, their funding costs.
Disclaimer: The views expressed in this post are those of the author and do not necessarily reflect the position of The Clearing House or its membership.