Congress and the Federal Reserve allowed payment of interest on bank reserves kept at the Federal Reserve to provide the Fed with a better tool to manage interest rates. Recently, some policymakers have suggested Congress should prohibit the Federal Reserve from paying interest on commercial banks’ and credit unions’ deposits at the Fed. Such a move has been suggested to save the government money but, in fact, eliminating interest on reserves would instead likely cost the government money and significantly harm the economy by pushing up long-term interest rates, boosting the federal deficit and curtailing the flow of credit to households and businesses.
Banks of all sizes have reserves at the Fed, and interest on reserve balances (IORB) is not a windfall to these banks.
- When a bank or credit union deposits money at the Fed, it is making a loan to the federal government, just like when a business or household buys a Treasury bill. Paying interest on reserves is no different from paying interest on Treasury bills.
Eliminating interest on IORB would reduce federal revenue.
- Eliminating IORB would trigger fire sales. If the IORB rate were set to zero, the Fed would need to rapidly and massively reduce reserve balances by selling Treasury securities and mortgage-backed securities, much of which would be sold at a loss.
- Losses would fall on the Fed and Treasury and federal borrowing costs would rise. Higher long-term interest rates on Treasuries would add to the federal deficit. Those losses would increase Fed operating losses, further delaying the day it can resume paying revenue to Treasury. The sales would also drive up Treasury rates, increasing federal financing costs and increasing the federal deficit.
- Reserves are not costly for the Fed. The Fed uses reserves to fund purchases of Treasury securities and mortgage-backed securities. It earns interest on the Treasuries and subsequently pays interest for the reserves. Payments the government would otherwise pay to holders of Treasury securities are instead paid to banks holding reserves, thereby cancelling each other out.
Eliminating IORB would severely harm the economy.
- Credit to the economy would shrink. A re-imposition of this implicit tax on banks would weaken the banking system and reduce the supply of bank credit.
- Market volatility would increase. Massive, rapid sales of Treasuries and mortgage-backed securities would be difficult for the financial system to handle, raising market volatility.
- Equity markets would decline. Equity prices would fall sharply in response to the rising rates and greater volatility.
- Short-term rates would collapse, resulting in higher inflation. If the Fed did not sell assets to reduce reserves but the IORB rate were zero, short-term interest rates would fall to zero. That would overstimulate the economy and drive up inflation.
- Long-term rates would spike, making loans costlier. Asset sales by the Fed would drive up longer-term interest rates, including mortgage rates, corporate bond rates and Treasury rates.
The policy solution: Instead of removing the Fed’s ability to pay interest on reserves, which would put the banking system at risk of instability, significantly harm the economy and remove a key monetary policy tool for the Fed to control interest rates, the Fed should continue winding down its balance sheet. This will result in the Fed paying less interest on reserves in general and will leave the Fed with a much smaller footprint in the financial system.
