WILL PAYING INTEREST ON RESERVES ENDANGER THE FED'S INDEPENDENCE?

• Author: Heller, Robert

The Federal Reserve started to pay interest on bank reserves during the Great Recession in 2008. These payments set an effective floor to the fed funds rate and allowed the Fed to determine short-term interest rates with great precision. Together with a greatly expanded balance sheet, the interest rate paid on reserves became the primary monetary policy tool by which the Fed implemented its monetary policy decisions during the last decade.

But the payment of interest on bank reserves had several side effects that were perhaps not fully recognized at the time that the decision was made. By paying interest on reserves, the Fed not only contributed significantly to the earnings of its member banks, but also influenced the size of the income transfers that the Fed regularly makes to the Treasury.

Consequently, the effects of monetary policy actions became directly linked to the operating revenues of the federal government and by this to fiscal policy.

As the Fed increasingly influences important fiscal variables, such as the size of the federal deficit, there looms the danger that politicians will attempt to influence the monetary policy actions of the Fed, thereby endangering the independence of the institution.

The Legislative History of Paying Interest on Reserves

The Federal Reserve began to pay interest on bank reserves in 2008 as the economy plunged into the Great Recession. Milton Friedman (1960) and others long argued that the Fed should compensate banks on their reserve holdings on economic efficiency grounds. Following this advice, Congress passed the Financial Services Regulatory Relief Act in 2006, which granted the Fed the authority to pay interest on reserves effective October 2011. When many banks experienced significant financial problems at the beginning of the Great Recession, Congress advanced the effective date of this provision to October 2008 to bolster the earnings of the struggling banks and to prevent additional bank failures. On October 9, 2008, the Federal Reserve began to pay interest to banks on both required and excess reserves.

While the interest payments on required reserves were justified on the economic efficiency grounds emphasized by Friedman, the Fed also started to pay interest on the excess reserve holdings to set a floor to the fed funds rate. The interest paid by the Fed on excess reserves established an effective lower bound to the fed funds rate because banks would not lend to each other at a lower premium than they could earn on their safe deposits at the Fed. This history is well documented by Selgin (2018) and Ireland (2019).

The Period of Low Interest Rates and Balance Sheet Expansion

At first, the payments to the banks on their reserve holdings were rather modest as the Fed pursued a low-interest rate policy and the reserve holdings by banks were relatively small. Starting in late 2008, the Fed set the floor to the fed funds rate at zero and the actual or effective fed funds rate stayed only a few basis points above this floor until 2015, when the Fed began to raise rates. The solid line in Figure 1 shows the lower limit to the fed funds rate set by the Fed during this period, while the dashed line displays the effective fed funds rate slightly above the floor rate set by the Fed. The monthly average of the effective fed funds rate never rose above 25 basis points during the years 2008-15. Because of the low rates prevailing during this period...