One of the most popular posts on this blog is one I wrote in
August 2011, “Why Does the Federal Reserve Pay Interest on
Required and Excess Reserves?” The question in the title is really
one for the Fed, since I found its explanations not entirely convincing. Recently,
I came across a more recent explanation
of the Fed’s interest rate payments on reserves policy at the Federal Reserve
Bank of San Francisco’s website.
After reading this, though, one still has to ask what the
point is of the Fed increasing its balance sheet and motivating banks not to
lend out their excess reserves to other banks. The FRBSF post argues that this
helps the Fed’s open market desk achieve its fed funds target by putting a
floor on the fed funds rate. But the current target is 0 to 25 basis points,
and zero is a floor. Moreover, if the reserves are just sitting at the Fed and
earning interest of 25 basis points, that helps the banks a bit by allowing
them to earn interest at no risk in excess of that available on Treasury bills
but it is hard to see how it helps the economy.
When I was at Treasury, we were skeptical of allowing the
Fed to pay interest on reserves. From a parochial standpoint, the payment of
interest on reserves reduces the Fed’s payments to the Treasury out of its
earning, resulting in increasing the amount Treasury has to borrow in the
market (or providing a shortfall that ultimately is covered by increasing
taxes).
In this regard, it is interesting to read that current Fed
Chair Janet Yellen appears to be at least somewhat skeptical of a Fed staff
paper discussing interest on reserves at the FOMC meeting in April 2008 (her
discussion of this begins on page 177 of the
minutes of that meeting). She analyzes the policy of not paying interest on
reserves as a tax on banks that would need to be replaced by another tax.
Recently, though, Yellen has suggested
that the Fed would raise the interest it pays on excess reserves when the
economy strengthens and the inflation rate has increased to the Fed’s 2%
target. (She does not seem to have said anything about interest on required
reserves.)
While this so far has not been a huge deal, it is hard to
avoid thinking that one of the reasons that the Fed pays interest on reserves
is that it is something that banks want. It seems similar to regulatory
capture, though I am sure Fed staff could reply vociferously against such a
charge. 
I think there are two distinct issues here: Why is the Fed currently paying interest on reserves, and why is the Fed talking about raising the interest rate it pays on reserves as the economy strengthens? On the first question, I think the answer is related to fears that lowering the interest rate on reserves in the current environment might cause disruptions in money markets that could end up making credit conditions tighter rather than looser. Some examples of potential disruptions were discussed here:
ReplyDeletehttp://libertystreeteconomics.newyorkfed.org/2011/11/why-is-there-a-zero-lower-bound-on-interest-rates.html
On the second question: When the FOMC decides it is appropriate to raise interest rates, actually implementing this decision will be challenging because of the Fed’s expanded balance sheet. One way to raise market interest rates without having to first shrink the balance sheet back to its pre-crisis size is to raise the interest rate paid on reserves (which would create a higher “floor” on market rates).