Friday, August 19, 2011
Why Does the Federal Reserve Pay Interest on Required and Excess Reserves?
When the Federal Reserve announced earlier this month that it would in all likelihood keep it fed funds rate target between 0 and 0.25% for the next two years, there was some comment that the Fed might not have any more very powerful tools left with which to jumpstart the current sluggish economy, which may be headed for another recession. One tool that is mentioned (for example, here by Alan Blinder) is for the Fed to lower the interest it pays banks on excess reserves. The mention of this possibility, though, raises the question of why the Fed is currently paying interest on both required and excess reserves on deposit at the Fed.
Prior to October 2008, the Fed did not pay interest on reserve balances. Prior to this, the Fed did not have the authority to pay interest on reserves. The Fed explains: "The Financial Services Regulatory Relief Act of 2006 originally authorized the Federal Reserve to begin paying interest on balances held by or on behalf of depository institutions beginning October 1, 2011. The recently enacted Emergency Economic Stabilization Act of 2008 accelerated the effective date to October 1, 2008."
The topic of paying interest on reserves came up from time to time when I was at Treasury. I and others at Treasury expressed some skepticism about this. Looking out for the Treasury (and, of course, the taxpayer), we pointed out that any interest the Fed paid would reduce its earnings and hence the amount of money the Fed pays to the Treasury. As far as the monetary policy arguments were concerned, they were never convincing. Looking at more recent Fed explanations, they still aren't.
In a Fed October 6 press release announcing that it would use its authority to pay interest on reserves, it justified paying interest on required reserves by stating: "Paying interest on required reserve balances should essentially eliminate the opportunity cost of holding required reserves, promoting efficiency in the banking sector." This more or less says giving money to banks that we were not able to in the past is a good thing. You could argue that not paying interest on reserves was a tax, though banks got a lot of privileges for paying that tax. The Fed statement hardly justifies repealing this tax, and it certainly does not justify paying them an above market rate, as the Fed is arguably currently doing.
Part of the Fed's case for excess reserves is somewhat more credible: "Paying interest on excess balances should help to establish a lower bound on the federal funds rate." Currently, though, it is not doing that since the fed funds rate is currently below the interest the Fed is paying on both required and excess reserves – 0.25%. It is not clear why any banks are lending at rates below the 25 basis points they can receive from the Fed, but that is what the Fed is reporting.
The second part of the Fed's case makes little sense: "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." No more explanation is given.
The President's Working Group on Financial Markets ("PWG") issued a statement on October 6 about the passage of the Economic Emergency Stabilization Act ("ESSA") which included a sentence reiterating the Fed's justification for paying interest on reserves: "… the authority to pay interest on reserves that was provided by EESA is essential, because it allows the Federal Reserve to expand its balance sheet as necessary to support financial stability while conducting a monetary policy that promotes the Federal Reserve's macroeconomic objectives of maximum employment and stable prices." On October 8, Treasury Secretary Henry Paulson issued statement on financial markets which included this on interest on reserves: "The EESA granted the Fed permanent authority to pay interest on depository institutions' required and excess reserve balances held at the Federal Reserve. This will allow the Fed to expand its balance sheet to support financial stability while maintaining its monetary policy priorities."
Since the Federal Reserve can expand its balance sheet at will by either buying securities or making loans, why paying interest on reserves is a necessary tool for expansion of its balance sheet is unexplained. Paying interest on excess reserves does save the Fed from criticism from the banks of having imposed a burden on the banks. Also, it might encourage banks from holding reserves in the form of vault cash beyond their needs, but that would seem to be a minor factor. The PWG and Paulson statements indicate an unquestioning deference to the Fed, particularly by Treasury, which is troubling. While some have argued that the Treasury has too much influence over the Fed, I would argue that, based on my experience and current observations, it has in recent times been the other way round.
It is hard to know how much of a factor interest on reserves has been in encouraging banks to sit on them. In a poor economy, there may not be that much of a demand for loans from creditworthy borrowers. But given that banks are earning more on their reserves than they could by, for example, buying three-month Treasury bills, it is hard to justify this payment to the banks. After one clears the smoke about the Federal Reserve Banks being private institutions in a legal sense, this is essentially taxpayer money. Given the current level of reserve balances held at the Federal Reserve Banks of more than $1.6 trillion dollars, an annual interest rate of 25 basis points amounts to more than $4 billion a year.
Finally, here is a picture that shows what has been happening to required and excess reserves since 2008: