Primer on Nontraditional Monetary Policy Tools: Paying Interest on Reserves

Standard lessons on the conduct of monetary policy include an introduction to these three policy tools in the Federal Reserve's tool kit: open market operations, the discount rate, and reserve requirements. But if your textbooks and standards are based on these traditional tools, they need an update. The severity of the 2007–09 recession led the Federal Reserve to dig a little deeper in the tool kit to pull out some nontraditional tools to go along with the traditional. One of these is the Fed now pays interest rates on required and excess reserve balances that depository institutions hold at Federal Reserve Banks.

It's important that your students understand the standard tools before you can discuss the less traditional ones, so let's back up a little.

Open market operations, one of the Fed's traditional tools, involves the buying and selling of U.S. Treasury and federal agency securities to achieve the Federal Open Market Committee's (FOMC) target for the federal funds rate. The fed funds rate is the interest rate for overnight lending of Federal Reserve balances between depository institutions. To achieve the FOMC's target, the Trading Desk at the New York Fed carries out the trades in the federal funds market through primary dealers.

The discount rate is a rate of interest that the regional Federal Reserve Banks charge commercial banks and other depository institutions for loans these institutions receive from the Fed's lending facility called the discount window.

Finally, depository institutions are required by law to hold a certain percentage of funds in reserve against their deposit liabilities. These are called required reserves. Depository institutions hold required reserves as either deposits with Federal Reserve Banks or as vault cash. Excess reserve balances exceed the reserve requirements established by law. Traditionally, banks have lent out their excess reserve balances to earn interest on these funds.

What exactly does it mean to pay interest on reserves (IOR), and what was the genesis?
Money that depository institutions held at the Fed did not earn interest, until a few years ago. This policy acted as an implicit tax on depository institutions. Without the requirement to hold those balances, banks could have earned interest on these balances as they lent them out in the banking system.

But in 2006, Congress passed the Financial Services Regulatory Relief Act, which granted the Federal Reserve authority to pay interest on both required and excess reserve balances (excluding vault cash). This legislation removed this tax on the banking system to create a more efficient flow of credit to interested borrowers.

Although this act was set to take effect in 2011, in October 2008, Congress passed the Emergency Economic Stabilization Act, which accelerated the date of implementation for this new nontraditional monetary policy tool.

Why did Congress accelerate the implementation of IOR in 2008?
Paula Tkac, a vice president and senior economist at the Federal Reserve Bank of Atlanta, explains IOR and the motivation for fast-tracking its effective date.

During 2008, excess reserve balances grew dramatically [see the chart below] as a result of the Federal Reserve's efforts to provide liquidity to markets and depository institutions during the financial crisis. With this large level of reserve balances, the Trading Desk at the New York Fed was having trouble during the early fall of 2008 in achieving the FOMC's desired target interest rate for "fed funds" (the name given to reserve balances lent across banks). Essentially, with all of the excess reserves in the system, banks were willing to lend to one another at rates well below the FOMC's target.

With the authority to pay interest on all reserve balances (not just required balances), the Federal Reserve is able to better control the fed funds rate, which is the primary tool for implementing monetary policy. Paying interest on reserves means that banks now have little or no incentive to lend fed funds at rates below the rate paid by the Federal Reserve.

Has IOR succeeded in providing a lower bound for the federal funds rate?
Paying IOR does not provide a perfect lower bound on the federal funds rate because the government-sponsored entities Fannie Mae and Freddie Mac, as well as insurance companies, can access the federal funds market. These institutions do not earn IOR because they do not have to maintain reserve balances with the Fed. Consequently, they lend funds at a rate below the 25 basis points paid on excess reserve balances.

Since December 2008, the FOMC has maintained the target federal funds rate at 0–25 basis points (0 to ¼ percent) and the interest rate on required and excess reserve balances (IOER) at 25 basis points (¼ percent; see the chart below). Because the IOER does not create an ideal lower bound for the target fed funds rate, the FOMC has set the fed funds rate as a range between 0 and 25 basis points.

Will the Federal Reserve continue to pay IOR?
Paula Tkac identified the ongoing significance of this new policy tool.

With the large level of excess reserve balances in the financial system, and lots of long-term assets like mortgage-backed securities and long-term Treasuries on the Fed's balance sheet, interest on reserves will continue to be a key tool for conducting monetary policy. The large level of excess balances means that the Fed cannot use small open market operations to affect the fed funds rate the way it used to. And the presence of long-term assets means that reserve balances will likely remain high for quite a while. The rate paid as interest on reserves will help the FOMC to control the fed funds rate to meet its dual mandate for maximum employment and price stability.

When the time comes for monetary policy to be tighter, the Fed can raise the IOR to give banks less incentive to lend, and slow the growth of the money supply in this way. This recent addition to the Fed's toolbox gives the Fed more flexibility to meet its dual mandate.

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By Amy Hennessy, senior economic and financial education specialist, Federal Reserve Bank of Atlanta
January 30, 2013