The encyclopedia · Finance & Accounting · Financial decision · 2008
Paying interest on reserves gave the Fed a floor for its target rate.
In 2008 the Fed began paying banks interest on reserves, creating an interest-rate floor and control amid a swollen balance sheet.
Federal Reserve Board
the move
In 2008 the Fed was expanding its lending to fight the crisis, and extra reserves would push the federal funds rate below target, undermining a basic tool of policy. It needed a way to hold rates even with a growing balance sheet.
The Emergency Economic Stabilization Act moved up an authorization that let the Fed pay interest on reserve balances. On 6 October 2008 the Board said it would pay on required balances, set at the average target funds rate less 10 basis points, and on excess balances, initially the lowest target rate less 75 basis points.
Paying interest on excess reserves gives banks an attractive place to park cash, so they will not bid the funds rate down to match the glut. That created a floor and, in effect, let the Fed decouple the size of its balance sheet from the stance of policy.
why it works
- Flooding the system with reserves drives the funds rate toward zero
- A bank holding reserves earns the interest rate, so it need not lend below it
- Paying on required balances removed the tax-like cost of meeting reserves
- It let the Fed lend aggressively while keeping rates on target
what transfers
You can set a floor under a rate by making an outside option attractive rather than by draining liquidity — that is institutional design, not a last resort.
what came after
Interest on reserves became the Fed's central rate-setting tool, later paired with an overnight reverse-repo facility to bracket the target. It let the Fed run a huge balance sheet through the next decade, though it also meant paying banks simply to hold reserves.
references
- Board announces that it will begin to pay interest on depository institutions' required and excess reserve balances
- Federal Reserve to Pay Interest on Required and Excess Reserve Balances
spotted an error? The archive wants to know.