Why is the Fed Paying Interest on Excess Reserves?

by on October 6, 2008 at 10:19 am in Economics | Permalink

Today the Fed starts to pay interest on reserves.  The zero interest on required reserves was an opportunity cost to banks, a tax if you like, so paying interest lifts the tax.  Reducing taxes on banks at the present time makes sense and in the long run there are some efficiency gains from paying interest on required reserves, especially to the extent that the previous system could be gamed.  Overall, however, this is small potatoes.

More interesting is why the Fed. will pay interest on excess reserves.  In the long run, there are again efficiency gains but why would the Fed. want to make it more profitable for banks to hold excess reserves now when we want every dollar in the credit markets?  My best guess is that the Fed. wants to play more Operation Twist and in Brad DeLong’s terms this gives them an additional tool to do it on the Pan-Galactic scale.  In short, they will buy long bonds and commercial paper or other such asset and use the interest payments on excess reserves to sterilize.  Although paying interest on excess reserves brings this whole operation under the Fed house it’s unclear to me, however, how the situation is markedly different than with Fed/Treasury cooperation.

1 sa October 6, 2008 at 10:44 am

interesting, i hadn’t thought about
this angle before.

i’ll add that sterilization in a market
expecting deflation is no good thing.

2 jean October 6, 2008 at 11:31 am

Fed deposit remuneration and Fed treasury cooperation are essentially the same: treasury bonds are the equivalent of Fed deposit.
The difference lie in liquidity: while Fed deposits are perfectly liquid treasury bond are not (it depends on the term of the bond).

The advantage of this approach is that Fed is more autonomous from treasury.

By the way, European Central Bank renumerates deposits at the “repo rate” since the beginning of the Euro (at 1% below the directing rate).

3 a student October 6, 2008 at 3:47 pm

I’m confused about what you mean by interest payments sterilizing the long bonds they buy. I can see why these payments will be setting a floor on the fed funds rate, maybe that’s what you mean. However, in what sense does it sterilize? The payments aren’t soaking up the money in any way?
And isn’t the difference with Fed/Treasury cooperation that this will let them hit the target?

4 Adam J January 13, 2009 at 7:06 pm

Saying that paying interest on required reserves is a TAX is totally off base. If not getting interest on your reserves is called a TAX then it is more then made up by the fact that they can lend out 10X there reserve amount…You can call that a 10 FOLD TAX CREDIT!

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