INTEREST ON RESERVES: HISTORY AND RATIONALE, COMPLICATIONS AND RISKS.

• Author: Ireland, Peter N.

Among the enduring legacies of the 2007-09 financial crisis, interest on excess reserves (IOER) now plays a central role in the Federal Reserve's policymaking framework. Famous arguments justify paying interest on required (but not excess) reserves on economic efficiency grounds. However, the Fed has used its power to pay IOER to facilitate credit market interventions that extend well beyond those required by its traditional central banking functions--namely, conducting monetary policy to stabilize the aggregate nominal price level and acting as a lender of last resort to illiquid but solvent depository institutions. One must question the wisdom of making IOER a permanent part of the Fed's toolkit, given the resulting complications and risks.

History and Rationale

George Tolley (1957) and Milton Friedman (1960) first argued that since bank reserves can be created at zero marginal cost within a fiat money regime, economic efficiency dictates that the opportunity cost to banks of holding reserves should be driven to zero as well. Tolley and Friedman also pointed out that one way to satisfy this efficiency condition is for the central bank to pay interest on required reserves at a rate approximating those available on other safe and highly liquid short-term assets, such as United States Treasury bills.

Based largely on this economic efficiency argument, it seems, the Financial Services Regulatory Relief Act of 2006 granted the Federal Reserve authority to begin paying interest on bank reserves, though the Act postponed the effective date for its interest-on-reserves provision to October 1, 2011. The Emergency Economic Stabilization Act of 2008 pulled this effective date forward to October 1, 2008. On October 6, 2008, the Federal Reserve Board announced plans to begin paying interest on required and excess reserves at rates 10 and 75 basis points, respectively, below the Federal Open Market Committee's federal funds rate target. Two days later, the Federal Open Market Committee (FOMC) cut its target for the fed funds rate from 2 to 1.5 percent. Thus, on October 9, 2008, a new policy regime took hold, with the Fed paying banks interest at the rate of 1.4 percent on their required reserves and 0.75 percent on their excess reserves.

The Fed's October 6 press release (Federal Reserve Board 2008) offered a mixed rationale for the announced change in regime. Tolley and Friedman's efficiency arguments survived, explaining the higher interest rate on required reserves, which according to the press release would "essentially eliminate the opportunity cost of holding required reserves, promoting efficiency in the banking sector." The press release gave different reasons, however, for paying IOER:

Paying interest on excess balances should help establish a lower bound on the federal funds rate. The payment of interest on excess reserves will permit the Federal Reserve to expand its balance sheet as necessary to provide the liquidity necessary to support financial stability while implementing the monetary policy that is appropriate in light of the System's macroeconomic objectives of maximum employment and price stability. (1) In late 2007 and early 2008, the Federal Reserve successfully financed its Term Auction Facility and its lending to facilitate JP Morgan's purchase of Bear Stearns from sales of U.S. Treasury securities from its own portfolio. Nevertheless, the failure of Lehman Brothers and bailout of AIG in the fall of 2008 required far more emergency lending, which the Fed could finance only by creating new reserves. Ordinarily, reserve creation puts downward pressure on the fed funds rate. However, by paying IOER, the Fed hoped to place a floor beneath which the funds rate could not fall, since no bank will lend reserves in the federal funds market at rates below what it can receive on its deposits at the Fed.

Elsewhere I have provided a monetarist perspective of the Fed's decision to start paying interest on reserves (Ireland 2017). My view, which is consistent with the Fed's, interprets the fed funds rate as a market rate of interest rather than a policy tool, and emphasizes how the central bank uses its role as monopoly supplier of base money to stabilize the price level. Specifically, by paying IOER, the Fed shifted the demand curve for reserves to the right. This increase in demand allowed the Fed to simultaneously shift the supply curve for reserves to the right as required by emergency lending without also generating an increase in the aggregate nominal price level.

In hindsight, therefore, two aspects of the Fed's 2008 decision to begin paying IOER stand out. First, it made monetary policy tighter than it would have been, as measured either by the higher fed funds rate or the lower equilibrium price level implied by the shifting but still intersecting demand...