The Federal Reserve today issued a report defending its long-standing practice of paying interest on banks’ excess reserves held at the Fed. These payments are rising as the Federal Open Market Committee gradually raises rates and normalizes U.S. monetary policy.
“The payment of interest on reserves . . . is an essential tool for implementing monetary policy because it helps anchor the federal funds rate within the FOMC’s target range,” the Fed said in its semiannual monetary policy report, which comes a few days before Fed Chairman Jerome Powell testifies before the Senate Banking Committee. “This tool has permitted the FOMC to achieve a gradual increase in the federal funds rate in combination with a gradual reduction in the Fed’s securities holdings and in the supply of reserve balances.”
The practice of paying IOER began in October 2008, shortly before the federal funds rate dropped to zero, and the Fed argued that IOER was a valuable tool in reaching its policy goals through the crisis and recovery. Without the ability to pay IOER, Fed would have had to take a different approach — one, it said, that “likely would have involved a rapid and sizable reduction in the Federal Reserve’s securities holdings in order to put sufficient upward pressure on interest rates. . . . Such an approach to removing accommodation would have run the risk of disrupting financial markets, with adverse effects on the economy.”
The American Bankers Association has long supported the Fed’s practice. In 2016, ABA-sponsored research found that IOER was a critical monetary policy tool, especially in a rising-rate environment, and that IOER neither incentivized banks to avoid lending money nor contributed negatively to the federal budget.