It has long been recognized that uncompensated reserve balances act like a tax on banks and that banks as a result expend scarce resources to avoid holding them. The Fed itself has historically supported legislation to enable it to pay interest on reserve balances (e.g., Kohn 2003), as have economists (e.g., Goodfriend 2002), both for reasons of economic efficiency and to improve the implementation of monetary policy. The traditional argument against interest payment has been that it would reduce the Fed's earnings that are subsequently turned over to the Treasury (Feinman 1993b; Abernathy 2003). The purpose of this paper is to demonstrate the implications of paying interest on reserve balances on the daily operations of both the Fed and the Treasury. While the arguments here--for different reasons--generally are in favor of enabling the Fed to pay interest on reserve balances, more important than the actual payment of such interest is the perspective gained when considering in detail the operations of both in an environment where reserve balances earn interest.
The Accommodative Nature of the Fed's Operations and Interest Payment on Reserve Balances
In the federal funds market, banks borrow and lend reserve balances held in reserve accounts at the Fed; most of the trades are accomplished either through pre-existing lines of credit or arranged via brokers. The Fed uses open market operations, overdrafts (provided automatically whenever a bank's reserve account moves into negative balance), and overnight loans to ensure the quantity of reserve balances circulating is such that the federal funds rate remains as close as possible to the FOMC's target rate. Since reserve balances are liabilities on the Fed's balance sheet, banks in the aggregate have no effect upon their quantity; by definition, only changes in the Fed's balance sheet can alter the quantity of reserve balances. (1)
The Fed's necessary accommodation of the demand for reserve balances is obvious when one considers daily operations in the absence of reserve requirements. Without reserve requirements, banks hold non-interest-bearing reserve balances only to settle payments such as checks drawn on customer accounts or Fedwire funds transfers for direct payments to other banks or the Treasury, or as settlement of netted clearinghouse transactions. In order to avoid the Fed's overdraft charges (discussed in Fullwiler 2003), banks desire to hold sufficient reserve balances to settle their net payment commitments for the day. A bank holding less than this amount would attempt to borrow more reserve balances, while one holding more would attempt to lend the excess. In the aggregate, too many or too few reserve balances circulating leads to wide swings in the federal funds rate since such lending/borrowing among banks does not affect the aggregate quantity of reserve balances. Too few balances could also threaten the smooth functioning of the payments system, which the Fed is charged in the Federal Reserve Act with protecting. Larger quantities of reserve balances do not "fund" more money creation since there is no operative constraint on bank lending beyond the existence of willing, creditworthy borrowers. In other words, loans create deposits while reserve balances only settle payments (Moore 1988; Wray 1998, 2003-4; Fullwiler 2003).
Adding reserve requirements is simply one way to reduce potential volatility in the federal funds rate. First, reserve requirements require banks to hold more reserve balances and thereby reduce the likelihood of overnight overdrafts. Second, because reserve requirements are met on average across a lengthy maintenance period, deficiencies or surpluses on most days can be offset later in the maintenance period. Together these provide "room for error" for the Fed as it attempts to correctly forecast the demand for reserve balances at the target rate (Fullwiler 2003). However, reserve balances still do not "fund" money creation and are still necessarily supplied endogenously to accommodate banks' demand for them--albeit as a daily average across the maintenance period.
Concerns expressed in recent years about increased variability in the federal funds rate due to falling required reserves (reviewed in Fullwiler 2003) or due to e-money-related innovations to the payments system (reviewed in Fullwiler 2004) often did not consider the regulatory factors enabling such volatility in the first place. Specifically, the possible range of variability in the federal funds rate is determined by the spread between the rate the Fed pays on reserve balances and the rate the Fed charges for overnight overdrafts (hereafter, referred to as simply the "spread"). As reserve balances have historically been non-interest-bearing while the Fed also strongly discouraged borrowing at the discount window to cover an overdraft (which themselves carry significant penalties if not covered by the end of the business day), the "spread" has effectively been very wide. The Fed had earlier relied on reserve requirements and its ability to...