September 25, 2017
Why Pay Interest on Required Reserve Balances?
The Federal Reserve has paid interest on reserves held by banks in their Fed accounts since 2008. Why should it do so? Here, we describe some benefits of paying interest on required reserve balances. Since forcing banks to hold unremunerated reserves would be akin to levying a tax on them, paying interest on these balances is a way to eliminate or greatly reduce that tax and its negative effects.
What Are Reserves?
Reserves are balances held by depository institutions (hereafter, banks) in accounts at their regional Federal Reserve Bank, which are comparable to checking accounts at a commercial bank. The Federal Reserve Act provides the authority for the Fed to set reserve requirements on banks. Reserve requirements are an amount equal to a given fraction of a bank’s net transaction accounts. Banks satisfy these requirements by holding cash in their vaults and, if that cash is insufficient, by keeping reserve balances at the Fed. This amount—reserve requirements minus vault cash—is a bank’s reserve balance requirement. Banks must satisfy their reserve balance requirements regardless of whether these reserves are remunerated.
Why Should Banks Be Forced to Hold Reserves?
Before the Fed could pay interest on reserves, it provided a supply of reserves that was close to the total level of banks’ demand. This “scarcity” of reserves was important to achieving the target for the level of the FOMC’s policy rate, the federal funds rate. Reserve balance requirements provided a stable and predictable level of bank demand for the Fed to target. The Federal Reserve Act specifies that the Fed can administer reserve requirements to create this demand to facilitate monetary policy implementation (a Federal Reserve Bulletin article by Joshua Feinman details the current purpose of reserve requirements as well as their historical uses).
Since the financial crisis, the supply of reserves has increased sharply as a result of the Fed’s lending facilities and asset purchase programs; consequently, the Fed can no longer rely on reserve scarcity to target rates. Instead, amidst an abundance of reserve supply relative to demand, the Fed is using interest on excess reserves as its primary tool to successfully target the federal funds rate. The overnight reverse repurchase agreement facility is also used, as a supplementary tool.
Aside from meeting their reserve requirements, banks use reserves to settle payments, either from customer traffic or as a result of proprietary transactions. Interbank payments are necessary to allow consumers to purchase the goods they want, even if they don’t use the same bank as the seller, or for workers to receive their wages, even if they don’t use the same bank as their employers. Some banks may choose to hold more reserves than required in order to accommodate their settlement needs.
The “Reserve Tax”
If reserves are not remunerated, then forcing a bank to fulfill reserve requirements is similar to imposing a kind of “reserve tax.” Banks would be willing to hold a certain amount of reserves for self-interested reasons. Beyond that level, banks will take action to avoid the tax, unsurprisingly. This would be particularly true as nominal interest rates increase, pushing up the opportunity cost of holding unremunerated reserves. Fed Governors Laurence Meyer and Donald Kohn discussed this incentive in testimony before Congress in the years leading up to the Fed receiving the authority to pay interest on reserves (1998, 2000, 2001, 2003, 2004, and 2006)....MUCH MORE