from Liberty Street Economics
–this post authored by Laura Lipscomb, Antoine Martin, and Heather Wiggins
The Federal Reserve has paid interest on reserves held by banks in their Fed accounts since 2008. Why should it do so? Here, we describe some benefits of paying interest on required reserve balances. Since forcing banks to hold unremunerated reserves would be akin to levying a tax on them, paying interest on these balances is a way to eliminate or greatly reduce that tax and its negative effects.
What Are Reserves?
Reserves are balances held by depository institutions (hereafter, banks) in accounts at their regional Federal Reserve Bank, which are comparable to checking accounts at a commercial bank. The Federal Reserve Act provides the authority for the Fed to set reserve requirements on banks. Reserve requirements are an amount equal to a given fraction of a bank’s net transaction accounts. Banks satisfy these requirements by holding cash in their vaults and, if that cash is insufficient, by keeping reserve balances at the Fed. This amount – reserve requirements minus vault cash – is a bank’s reserve balance requirement. Banks must satisfy their reserve balance requirements regardless of whether these reserves are remunerated.
Why Should Banks Be Forced to Hold Reserves?
Before the Fed could pay interest on reserves, it provided a supply of reserves that was close to the total level of banks’ demand. This “scarcity” of reserves was important to achieving the target for the level of the FOMC’s policy rate, the federal funds rate. Reserve balance requirements provided a stable and predictable level of bank demand for the Fed to target. The Federal Reserve Act specifies that the Fed can administer reserve requirements to create this demand to facilitate monetary policy implementation (a Federal Reserve Bulletin article by Joshua Feinman details the current purpose of reserve requirements as well as their historical uses).
