The Atlanta Fed's macroblog provides commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues.

Authors for macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.

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October 07, 2008

“Why is the Fed Paying Interest on Excess Reserves?”

That’s the question that perplexes Alex Tabarrok. But he has a theory (which is endorsed by William Polley):

“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…

“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.”

Operation Twist refers to monetary policies deliberately aimed at manipulating the prices of particular assets. The idea is for the central bank to “buy” the targeted assets with central bank money—reserves—or short-term government debt. In the original instance of Operation Twist, the targeted assets were long-term government debt. In the present instance, the assets are presumably the various classes of illiquid private assets that have been targeted by various Federal Reserve lending facilities.

To me, that explanation is just a little too complicated. We like to make it clear that we here at macroblog do not speak for the Federal Reserve, but in this case the Federal Reserve (Board) spoke for itself in a questions and answers document on interest on reserves:

“Why does the Federal Reserve want to pay interest on excess balances?

“Paying interest on excess balances should help to establish a lower bound on the federal funds rate by lessening the incentive for institutions to trade balances in the market at rates much below the rate paid on excess balances. Paying interest on excess balances will permit the Federal Reserve to provide sufficient liquidity to support financial stability while implementing the monetary policy that is appropriate in light of the System’s macroeconomic objectives of maximum employment and price stability. For more information about the implementation of monetary policy with the payment of interest on required reserve balances and excess balances, please see the Federal Reserve Bank of New  York’s website at www.newyorkfed.org.”

A quick look at the data reveals pretty clearly why establishing the lower bound on the funds rate might be of particular interest at the moment. Below is a graph of the daily low in the effective federal funds rate since the end of April (when the federal funds rate target was cut to 2 percent, its current level)…

Effective Funds Rate, Daily Low

… and a graph showing the standard deviation of the daily rate over the same time period.

Effective Funds Rate, Daily Low

As these pictures clearly illustrate, since mid-September the daily effective funds rate lows have been consistently very low, often hitting zero, and the intraday volatility unusually high. This period corresponds to an accelerated use of the various Federal Reserve lending facilities—acquisitions of the Bear Stearns-related Maiden Lane LLC (ML), liquidity assistance to AIG, the Primary Dealer Credit Facility (PDCF), and the Money Market Mutual Fund Liquidity Facility (AMLF), in particular—which have expanded the reserves available to the banking system:

Effective Funds Rate, Daily Low

As noted at Real Time Economics

“The change will encourage banks to leave more money on deposit at the Fed, and that’ll give the Fed more maneuvering room to lubricate the financial system and lend to troubled institutions without increasing the total supply of credit in the economy and pushing down the federal funds interest rate, the Fed’s key interest rate tool.”

This description is just another way of saying what the Federal Reserve said in its questions and answers document released yesterday: “Paying interest on excess balances will permit the Federal Reserve to provide sufficient liquidity to support financial stability while implementing the monetary policy that is appropriate in light of the System’s macroeconomic objectives of maximum employment and price stability.”

Sometimes the simple explanation is the best one.

UPDATE: William Polley follows up.

October 7, 2008 in Federal Reserve and Monetary Policy | Permalink


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Great explanation, thank you - we looked at the same data a couple days ago (http://macrobuddies.blogspot.com/2008/10/steering-fed-funds-rate.html)

It will be interesting to see if the Standard Deviation starts to come down with this change.

Do you have any view on the other major monetary policy change, which allows the Federal Reserve to set the Required Reserve Ratio to any level (including zero), from its current rate of 10% (on larger deposits) ?

Posted by: Murph | October 07, 2008 at 04:18 PM

Reserves are not a tax. Add $1 bill of legal reserves to the banking system and the commercial banks then acquire $100+ bill in earning assets. Then the Treasury recaptures 97%? of the interest on these assets. A good game for all involved.

Legal reserves are a credit control device. The money supply can never be managed by any attempt to control the cost of credit.

Why not drop rates to zero? Just larger interest rate differentials or spreads (higher profits)for the borrowers.

Proper monetary policy involves getting the commercial banks out of the savings business (e.g. reductions, July 20, 1966 & Sept 6, 1966 in the 1966 housing crisis)-- the first reductions since Feb 1, 1935). There was an immediate increase in the supply of loan funds, reductions in long-term & short-term interest rates, increases in bank profits, reductions in inflation, & favorable effects on unemployment & production.

Posted by: flow5 | October 08, 2008 at 02:34 PM

Ive been following some of your post and like what you have done, i had a question/comment on your resent blog, i think its probably time for the government to step out of the picture and let the free markets rip appart all of the banks. I know that would cause havoc for a period of time but its better then the government trying to fix the private sector which it clearly has no ability to do.

Posted by: Free Refinance Guru | October 09, 2008 at 05:33 PM

Legal Reserves are NOT a tax. The only tax is INFLATION.

Posted by: flow5 | October 17, 2008 at 01:45 PM

Isn't one of the main objectives of all the Fed activity to get banks to lend in the market. So why make it more expensive to lend overnight? That's what needs to be explained.

Posted by: joebek | October 18, 2008 at 07:22 PM

very interesting explanation, thank you. I would like to update graph 3 on Federal reserve assets, but I don't know where I can get the data. I see they are from Fed Reserve Board H.4.1, but it is not possible to get the times series using the "data download program" available on the Board of Governors web site. Do you have any suggestions? Thanks a lot

Posted by: silvio | October 24, 2008 at 05:01 PM

Why isn't it working? FF's have traded at 1bp in two of the last four trading days?

Posted by: Ray Zemon | November 04, 2008 at 06:34 PM

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