What Is the IORB Rate? A Key Fed Monetary Policy Tool

The Interest on Reserve Balances (IORB) rate is a tool used by the Federal Reserve to implement monetary policy. It represents the interest the Federal Reserve pays to commercial banks on funds held in their accounts at the Federal Reserve. Its purpose is to influence short-term interest rates across the financial system. The IORB rate emerged as a central instrument following the 2008 financial crisis, signaling a shift in the Federal Reserve’s approach to managing money supply and credit conditions.

Congress granted the Federal Reserve the ability to pay interest on reserves in 2006, effective 2011. However, the Emergency Economic Stabilization Act of 2008 accelerated this authority to October 1, 2008, due to the financial crisis. Initially, two separate rates existed: interest on required reserves (IORR) and interest on excess reserves (IOER). These combined into a single IORB rate on July 29, 2021, simplifying the framework.

Understanding Bank Reserves

Bank reserves are funds commercial banks hold either physically in their vaults or as deposits in their accounts at the Federal Reserve. These reserves are a portion of a bank’s deposits set aside to meet financial obligations and regulatory requirements. Historically, banks were mandated to hold a specific percentage of their deposits as “required reserves.”

Required reserves served as a minimum cash buffer, ensuring banks could meet unexpected withdrawal demands and maintain liquidity. Funds held by banks above this minimum were termed “excess reserves.” Prior to 2020, banks minimized excess reserves because these funds did not earn interest and could lose value due to inflation, incentivizing lending.

Since March 26, 2020, the Federal Reserve set all reserve requirement ratios for transaction accounts to zero percent, eliminating required reserves. Despite this change, banks continue to hold substantial balances at the Federal Reserve. These balances are maintained for facilitating payment obligations, clearing transactions, and managing liquidity. Holding reserves at the Federal Reserve provides a safe place for funds.

The Mechanics of the IORB Rate

The Federal Reserve pays interest on reserve balances maintained by eligible financial institutions in master accounts at Federal Reserve Banks. This IORB rate is determined by the Board of Governors of the Federal Reserve System. Interest is calculated daily by multiplying the end-of-day balance by the IORB rate in effect for that day.

The IORB rate directly influences the Federal Reserve’s “ample reserves” framework for managing the federal funds rate. The federal funds rate is the interest rate at which banks lend reserves to each other overnight. The IORB rate effectively sets a floor for this market rate because banks are unlikely to lend reserves to other institutions at a rate lower than what they can earn directly from the Federal Reserve.

When the Federal Open Market Committee (FOMC) adjusts its target range for the federal funds rate, it adjusts the IORB rate in tandem. For instance, if the FOMC decides to raise the federal funds rate target, it will increase the IORB rate. This increase makes holding reserves at the Fed more attractive for banks, encouraging them to keep funds at the central bank rather than lending in the federal funds market. Conversely, lowering the IORB rate incentivizes banks to lend more, putting downward pressure on the federal funds rate. This mechanism helps steer the market-determined federal funds rate within the FOMC’s desired target range.

The IORB Rate’s Role in Monetary Policy

The IORB rate is central to the Federal Reserve’s implementation of monetary policy, as changes in this rate influence other interest rates throughout the economy, impacting borrowing costs for businesses and consumers. When the Federal Reserve raises the IORB rate, it generally leads to an increase in interbank lending rates, as banks demand a higher return for lending funds to other institutions. This upward pressure can then transmit to other rates, such as prime rates and consumer lending rates for mortgages, auto loans, and credit cards.

This influence helps the Federal Reserve achieve its dual mandate of maximum employment and price stability. To combat inflation, the Federal Reserve might implement a “tightening” monetary policy. This involves increasing the IORB rate, which raises overall borrowing costs and dampens consumer spending and business investment, thereby slowing economic activity and reducing inflationary pressures.

Conversely, if the economy is sluggish and unemployment is high, the Federal Reserve might pursue an “easing” monetary policy. In this scenario, the IORB rate would be lowered. Lowering the IORB rate makes it less attractive for banks to hold funds at the Federal Reserve, encouraging them to lend more to consumers and businesses. This stimulates borrowing and spending, fostering economic growth and job creation. The IORB rate, alongside other tools, allows the Federal Reserve to manage the supply of money and credit to guide the economy toward its objectives.