It’s a recent invention of the Fed to pay interest to banks on reserve deposits
ID: 1119601 • Letter: I
Question
It’s a recent invention of the Fed to pay interest to banks on reserve deposits held there. The current interest rate is an annual rate of 1.25%, and it applies to both required reserves and excess reserves.
There’s something about this innovation that strikes me as being rather odd. The interest innovation was introduced during a time when the Fed was concentrating intensely on a program of Quantitative Easing. One might expect the introduction of interest payments to be part of a tightening policy rather than an easing policy: If banks are suddenly able to earn money by holding excess reserves, we might expect that to discourage lending rather than encourage it, resulting in less easing in credit markets. If banks are now able to earn a return without incurring risks and without administrative expenses, would we not expect that to reduce their motivation to lend money into the private economy?
Hence, this (last) question of the week: What argument(s) do you believe might be reasonably made in support of the view that Fed interest payments on bank reserves might not conflict with the goals of a program of monetary easing?
Explanation / Answer
*Reserve balances are reserves held by banks above their reserve balance requirements. Banks aren’t required to hold excess reserve balances and they can adjust the level of their holdings by borrowing or lending reserves. However, the aggregate amount of reserves in the banking system is controlled by the Fed
*The Fed influences the economy by raising and lowering its target for the federal funds rate, the interest rate at which banks lend reserves,changes in the federal funds rate in turn influence other interest rates and asset prices
*By making bank reserves more scarce, the Fed pushes up the price of reserves ie the federal funds rate. By making reserves more it push down the funds rate.
* Banks are satisfied with reserves, changes in the supply of reserves will no longer have much influence on the federal funds rate. Fed now manages the federal funds rate by changing the rate of interest it pays on reserves.These changes influence the federal funds rate and other short-term funding rates, and thus financial conditions
*conducting monetary policy with a relatively abundant supply of reserves has multiple benefits,it makes the payment system more efficient and it reduces the reliance of the financial system on intraday credit from the Fed
*There is a persistent differential between banks funding costs and the interest rate they receive on reserves suggests that there may be additional costs to banks of holding reserves, above the explicit marginal cost of funding.
The factors influencing why paying to bank is necessary ie;
*The Fed has already announced that, at some point, it will stop reinvesting the proceeds from maturing securities, thereby allowing its balance sheet to shrink to its pre-crisis size. As the balance sheet shrinks, the quantity of outstanding bank reserves. The Fed could therefore emphasize that it expects that the need to make substantial iinterest payments to banks is temporary, and that those payments will shrink as the balance sheet normaliz and the Fed returns
* Fed is currently targeting a 25-point range for the federal funds rate, with the interest rate on reserves at the top end of that range the Fed should be able to shrink its target range, with the effect that the federal funds rate will draw even closer to the interest rate paid. It should then be easier to explain why banks are not receiving a subsidy from the Fed, it will be evident that they are earning about the same on their reserves as they could receive in the open market.
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