Why Does the Fed Pay Interest to Banks?

The Federal Reserve’s practice of paying interest to banks on the funds they hold at the central bank may initially seem puzzling to many. This mechanism, however, is not a subsidy but a fundamental tool of modern monetary policy. It allows the Federal Reserve to effectively manage the financial system and steer the economy towards its objectives.

Understanding Bank Reserves

Bank reserves are the funds that commercial banks hold in their accounts at the Federal Reserve. These balances are distinct from the cash held in a bank’s vault. Historically, banks were required to maintain a certain percentage of their deposits as “required reserves” with the Federal Reserve.

While the concept of required reserves existed, the Federal Reserve set reserve requirement ratios to zero percent in March 2020. Despite this change, banks continue to hold funds at the Federal Reserve. These holdings, now considered “excess reserves” in the absence of a mandate, serve various purposes, including facilitating interbank payments, managing daily liquidity needs, and meeting regulatory requirements that emphasize financial stability.

How Interest on Reserve Balances Works

The Federal Reserve pays interest on these reserve balances, a practice known as Interest on Reserve Balances (IORB). This interest is paid on all reserve balances held by eligible institutions at the Fed. The authority for the Fed to pay interest on reserves was granted by Congress in 2008. IORB is now a single rate that applies to all reserve balances. The Federal Reserve Board sets this IORB rate, and the interest amount is calculated by multiplying the daily IORB rate by the end-of-day balance maintained by a bank.

The Federal Reserve’s Monetary Policy Objectives

Paying interest on reserves is a key component of the Federal Reserve’s strategy for implementing monetary policy within a “floor system.” In this framework, the IORB rate helps to establish a floor for the federal funds rate, which is the interest rate at which banks lend reserves to each other overnight. Banks are generally unwilling to lend their reserves to other institutions at a rate lower than what they can earn by simply holding those funds at the Federal Reserve.

By adjusting the IORB rate, the Federal Reserve directly influences the federal funds rate, thereby steering short-term interest rates throughout the economy. This mechanism is used to achieve the Federal Reserve’s dual mandate: fostering maximum employment and maintaining price stability.

A higher IORB rate encourages banks to hold more reserves, which can reduce the supply of funds available for lending and put upward pressure on market interest rates. Conversely, lowering the IORB rate can incentivize banks to lend more, putting downward pressure on rates. It allows the Federal Reserve to manage the supply and demand for reserves in the banking system and effectively guide short-term interest rates to support its economic objectives.

Broader Economic Implications

Adjustments to the Interest on Reserve Balances (IORB) rate by the Federal Reserve affect the entire economy. Since the IORB rate influences the federal funds rate, it consequently affects other interest rates that consumers and businesses encounter. This includes rates on mortgages, car loans, credit cards, and various business loans.

When the Federal Reserve raises the IORB rate, leading to higher borrowing costs across the economy, consumer spending tends to decrease as loans become more expensive. Businesses may also reduce their investments and expansion plans due to increased costs of financing. Conversely, lower interest rates, influenced by a reduced IORB, make borrowing cheaper, which can stimulate consumer spending and encourage business investment, thereby fostering economic growth.

Higher interest rates can cool an overheating economy by reducing demand, which helps to curb inflation and stabilize prices. Alternatively, lower rates can stimulate economic activity, but if unchecked, they can contribute to inflationary pressures. The IORB rate also impacts bank profitability and lending behavior, as banks weigh the returns from holding reserves at the Fed against the potential returns and risks of lending to customers.