Why is the Fed Paying Interest on Excess Reserves?
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.