Primer on Nontraditional Monetary Policy Tools: Paying Interest on Reserves
Standard lessons on the conduct of monetary policy include an introduction to these three policy tools in the Federal Reserve's tool kit: open market operations, the discount rate, and reserve requirements. But if your textbooks and standards are based on these traditional tools, they need an update. The severity of the 2007–09 recession led the Federal Reserve to dig a little deeper in the tool kit to pull out some nontraditional tools to go along with the traditional. One of these is the Fed now pays interest rates on required and excess reserve balances that depository institutions hold at Federal Reserve Banks.
It's important that your students understand the standard tools before you can discuss the less traditional ones, so let's back up a little.
Open market operations, one of the Fed's traditional tools, involves the buying and selling of U.S. Treasury and federal agency securities to achieve the Federal Open Market Committee's (FOMC) target for the federal funds rate. The fed funds rate is the interest rate for overnight lending of Federal Reserve balances between depository institutions. To achieve the FOMC's target, the Trading Desk at the New York Fed carries out the trades in the federal funds market through primary dealers.
The discount rate is a rate of interest that the regional Federal Reserve Banks charge commercial banks and other depository institutions for loans these institutions receive from the Fed's lending facility called the discount window.
Finally, depository institutions are required by law to hold a certain percentage of funds in reserve against their deposit liabilities. These are called required reserves. Depository institutions hold required reserves as either deposits with Federal Reserve Banks or as vault cash. Excess reserve balances exceed the reserve requirements established by law. Traditionally, banks have lent out their excess reserve balances to earn interest on these funds.
What exactly does it mean to pay interest on reserves (IOR), and what was the genesis?
But in 2006, Congress passed the Financial Services Regulatory Relief Act, which granted the Federal Reserve authority to pay interest on both required and excess reserve balances (excluding vault cash). This legislation removed this tax on the banking system to create a more efficient flow of credit to interested borrowers.
Although this act was set to take effect in 2011, in October 2008, Congress passed the Emergency Economic Stabilization Act, which accelerated the date of implementation for this new nontraditional monetary policy tool.
Why did Congress accelerate the implementation of IOR in 2008?
With the authority to pay interest on all reserve balances (not just required balances), the Federal Reserve is able to better control the fed funds rate, which is the primary tool for implementing monetary policy. Paying interest on reserves means that banks now have little or no incentive to lend fed funds at rates below the rate paid by the Federal Reserve.
Has IOR succeeded in providing a lower bound for the federal funds rate?
Since December 2008, the FOMC has maintained the target federal funds rate at 0–25 basis points (0 to ¼ percent) and the interest rate on required and excess reserve balances (IOER) at 25 basis points (¼ percent; see the chart below). Because the IOER does not create an ideal lower bound for the target fed funds rate, the FOMC has set the fed funds rate as a range between 0 and 25 basis points.
Will the Federal Reserve continue to pay IOR?
When the time comes for monetary policy to be tighter, the Fed can raise the IOR to give banks less incentive to lend, and slow the growth of the money supply in this way. This recent addition to the Fed's toolbox gives the Fed more flexibility to meet its dual mandate.
By Amy Hennessy, senior economic and financial education specialist, Federal Reserve Bank of Atlanta
January 30, 2013