Interest on Reserves and Inflation

There’s been a lot of talk lately about the Fed’s policy of paying interest on reserves with many claiming that this has caused banks to retain reserves that might have otherwise been turned into loans, and thus the policy has depressed aggregate activity. However, paying interest on reserves is a safety net for the Fed that allowed them to do QEI and QEII. If the Fed wasn’t paying interest on reserves, QEI would have likely been smaller, and QEII may not have happened at all.

First, on whether paying interest on reserves is a constraint on loan activity, the supply of loans is not the constraining factor, it’s the demand. Increasing the supply of loans won’t have much of an impact if no firms aren’t interested in making new investments. Businesses are already sitting on mountains of cash they could use for this purpose, but they aren’t using the accumulated funds to make new investments and it’s not clear how making more cash available will change that.

Second, I doubt very much that a quarter of a percentage interest — the amount the Fed pays on reserves — is much of a disincentive to lending (market rates have fluctuated by more than a quarter of a percent without a having much of an impact on investment and consumption).

Third, this a safety net for the Fed with respect to inflation. Paying interest on reserves gives the Fed control over reserves they wouldn’t have otherwise, and control of reserves is essential in keeping inflation under control. If, as the economy begins to recover, the Fed loses control of reserves and they begin to leave the banks and turn into investment and consumption at too fast a rate, then inflation could become a problem.

But by changing the interest rate on reserves, the Fed can control the rate at which reerves exit banks. The incentive to loan money is the difference between what the bank can earn by loaning the money or purchasing a financial asset and what it can make by holding the money as reserves. Suppose, for example, that the Fed raises the interest rate on reserves to the market rate of interest. In that case, banks would have no incentive at all to make loans and would instead just hold the reserves.

The tool the Fed has for removing reserves from the system is open market operations (QEI and QEII are essentially traditional open market operations, but the Fed buys long-term rather than the more traditional short-term financial assets). So why do they need another tool — interest on reserves — to control reserves? Removing reserves too fast through open market operations could disrupt financial markets. Paying interest on reserves gives the Fed a way to remove reserves in a more leisurely fashion while still maintaining control over inflation. They can raise the interst rate on reserves freezing them within the banking system, and then remove the reserves over time as desired.

To say this another way, traditionally the only way the Fed could raise the federal funds rate is through open market operations that remove reserves from the system. However, since interest on reserves is a floor for the federal funds rate (it’s a floor because nobody would lend reserves at a rate less than they can earn by holding them), an increase in the rate the Fed pays on reserves will increase the federal funds rate even though the reserves are still in the system. The economy can be slowed through increases in the federal funds rate without having to remove substantial quantities of reserves all at once as would be the case if open market operations were the only tool available.

Thus, though I don’t think paying interest on reserves has much of an effect on loan activity right now, even if you believe it has, this is the price that must be paid for the ability to do QEI and QEII. If the Fed did not have this tool avaialble, it would be much more fearful about its ability to control inflation, and much less likely to try to use unconventioanl policy to spur the economy.

About Mark Thoma 243 Articles

Affiliation: University of Oregon

Mark Thoma is a member of the Economics Department at the University of Oregon. He joined the UO faculty in 1987 and served as head of the Economics Department for five years. His research examines the effects that changes in monetary policy have on inflation, output, unemployment, interest rates and other macroeconomic variables with a focus on asymmetries in the response of these variables to policy changes, and on changes in the relationship between policy and the economy over time. He has also conducted research in other areas such as the relationship between the political party in power, and macroeconomic outcomes and using macroeconomic tools to predict transportation flows. He received his doctorate from Washington State University.

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