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What Is Interest on Reserves and Why Does the Fed Pay It?

Interest on reserves (IORB, or sometimes called interest on reserve balances) is the rate the Federal Reserve pays banks on the reserves they hold at the Fed. When a bank deposits money at the Federal Reserve—either required reserves that regulations mandate or excess reserves the bank chooses to hold—the Fed pays interest on that balance. This seemingly technical banking feature is actually a powerful monetary policy tool because it influences banks' decisions about lending versus holding reserves. If the Fed pays a high interest rate on reserves, banks are incentivized to hold money at the Fed rather than lend it out, reducing credit availability. If the Fed pays zero or low interest, banks are incentivized to lend reserves out to borrowers, expanding credit. Understanding interest on reserves reveals how central banks can subtly influence lending decisions and steer the economy without directly mandating behavior.

Interest on reserves is the rate the Federal Reserve pays banks on their reserve balances, influencing banks' lending decisions by making reserves more or less attractive relative to loans.

Key Takeaways​

  • The Fed pays interest on reserves held at its balance sheet, incentivizing banks to either lend out reserves or hold them depending on the interest rate level
  • Higher interest on reserves encourages banks to hold more reserves, effectively removing those funds from the lending market and tightening monetary conditions
  • Lower interest on reserves encourages banks to lend, increasing the money supply and credit availability to borrowers
  • Interest on reserves became a policy tool only in 2008 when the Fed started paying interest on the reserves it created through quantitative easing
  • The interest rate on reserves is closely related to the federal funds rate, the overnight rate at which banks lend to each other
  • Interest on reserves helps the Fed control money supply when traditional interest rate policy reaches the zero lower bound, making it possible to maintain policy traction even when overnight rates cannot fall further

The Evolution: How Interest on Reserves Became a Policy Tool​

To understand why the Fed pays interest on reserves, we must understand how and why this tool was created.

Before 2008, the Fed paid zero interest on required reserves. Banks had to hold required reserves as a regulatory matter, but received nothing in return. Excess reserves—reserves beyond the required amount—also earned zero interest. Banks would only hold excess reserves if they anticipated future deposit outflows or if they viewed excess reserves as safer than other assets. In normal conditions, banks held minimal excess reserves and quickly lent them out.

The situation changed dramatically in 2008. As the financial crisis unfolded, the Fed cut the federal funds rate target to zero (you cannot charge negative interest rates on overnight loans in practice). With short-term rates at zero, the Fed needed additional tools to stimulate the economy. One tool was quantitative easing—buying long-term securities to inject money into the banking system.

The Fed's quantitative easing created massive quantities of reserves—eventually over $1.5 trillion. The Fed needed banks to lend these reserves out to support credit growth. However, banks were terrified. The crisis had revealed unexpected losses in mortgage securities. Lehman Brothers, a supposedly safe investment bank, had collapsed. If banks lent out reserves and borrowers defaulted, the banks would suffer losses.

The Fed faced a problem: it had flooded the banking system with reserves, but banks were not lending them out. Reserves sat idle, earning nothing. The Fed decided to pay interest on these reserves as an incentive for banks to hold them (preventing panic sales of assets) while also making reserves attractive enough that banks would feel comfortable borrowing them from other banks, eventually supporting lending.

The Fed began paying interest on required reserves in October 2008. In December 2008, it began paying interest on excess reserves. The initial rate was 0.25% on required reserves and 0.10% on excess reserves. These rates were modest, but in an environment where short-term rates were zero, they were meaningful. A bank could get a guaranteed 0.10% return by holding reserves at the Fed, or face uncertain returns by lending into a chaotic credit market.

How Interest on Reserves Influences Bank Behavior​

Interest on reserves works through a direct incentive mechanism. Banks, like all businesses, attempt to maximize profit. Every dollar a bank holds in reserves is a dollar it is not lending out. If reserves earn nothing, the bank has a strong incentive to lend. If reserves earn a competitive interest rate, the bank faces a choice: lend the dollar at a 4% rate with some default risk, or hold it at the Fed earning 4% with zero risk.

This choice is especially clear during periods of economic stress. In 2009, after Lehman's collapse, mortgages were defaulting at unprecedented rates. A bank lending out $100,000 could expect that perhaps $10,000 would not be repaid. A bank holding $100,000 in Fed reserves earning 0.10% would receive a guaranteed $100. The risk-adjusted return on lending looked poor. Holding reserves looked better.

The Fed's interest on reserves performed several functions simultaneously. First, it supported financial stability by reducing pressure on banks to sell assets into weak markets. A bank that needs to maintain a certain reserve level might be forced to sell a mortgage security or Treasury bond to do so. In a stressed market, fire-sale prices are low. By paying interest on reserves, the Fed eliminated the need to sell assets.

Second, interest on reserves provided banks with a safe, profitable place to put deposits. This may seem backward—wouldn't paying interest on reserves encourage hoarding rather than lending? In practice, it helped. By guaranteeing banks a return on at least some portion of deposits, the Fed maintained banking system stability. Banks could afford to hold reserves and survive the crisis. Without the safety valve of interest on reserves, banks might have failed.

Third, interest on reserves gave the Fed a new monetary policy lever. By raising or lowering the interest rate on reserves, the Fed could influence how much reserves banks held versus how much they lent.

The Relationship Between Interest on Reserves and the Federal Funds Rate​

The federal funds rate (the overnight rate at which banks lend reserves to each other) and the interest on reserves (the rate the Fed pays on reserves) are closely linked, though distinct.

When the Fed sets its target for the federal funds rate (currently 4.25%-4.5% as of 2024), the actual federal funds rate is determined by supply and demand in the overnight lending market. Banks with excess reserves lend them to banks with shortfalls. The interest rate emerges from trading. The Fed uses open market operations to influence this rate by adjusting reserve supply.

Interest on reserves affects the federal funds rate by establishing a floor. Banks will not lend reserves to other banks at a rate lower than what the Fed pays. If the Fed pays 4% on reserves, a bank with excess reserves will not lend them overnight at 3% to another bank. Why accept 3% when the Fed guarantees 4%? This floor behavior means the federal funds rate cannot fall below the interest on reserves rate.

However, there is also a ceiling on the federal funds rate. This ceiling is created by the rate the Fed charges on its discount window—the facility where banks can borrow directly from the Fed. Banks will not pay more than the Fed's lending rate to borrow from other banks. If the Fed charges 4.5% on its lending facility, a bank will not pay 5% in the federal funds market.

Together, interest on reserves (the floor) and the discount rate (the ceiling) create a corridor. The federal funds rate trades within this corridor. The Fed maintains this rate corridor system deliberately to keep the federal funds rate near its target while minimizing the need for continuous open market operations.

Interest on Reserves at the Zero Lower Bound​

Interest on reserves became particularly important after 2008 because it allowed the Fed to maintain policy control even when the federal funds rate hit zero.

Normally, if the Fed wants to tighten policy (slow the economy and reduce inflation), it raises the federal funds rate. This makes reserves less attractive and increases the cost of borrowing for banks, businesses, and households. If the Fed wants to loosen policy (stimulate the economy and increase employment), it lowers the federal funds rate, making reserves less valuable and encouraging lending.

But the federal funds rate cannot go below zero (in practice; some central banks have experimented with negative rates, but this faces practical limitations and political resistance). If the nominal federal funds rate is already at zero, the Fed cannot lower it further using traditional policy. This situation is called the zero lower bound problem.

Interest on reserves provides a partial solution. Even if the federal funds rate is at zero, the Fed can pay positive interest on reserves. This makes reserves relatively attractive and discourages lending, effectively tightening policy from a position of zero rates.

From 2008-2015, the Fed kept the federal funds rate at zero while also paying interest on reserves. As the recovery progressed and inflation remained below target, the Fed actually raised the interest on reserves (through quantitative easing and forward guidance) to discourage excessive risk-taking. Banks earned a safe return on reserves, reducing pressure to seek risky returns through lending.

When the Fed began raising rates in 2015, it raised both the federal funds rate target and the interest on reserves rate together. By 2022, as inflation surged, the Fed raised the interest on reserves to 4.33% (the upper end of its target corridor). At this rate, holding reserves at the Fed was as attractive as lending money to creditworthy borrowers. The high rate discouraged new lending and helped reduce money supply growth, fighting inflation.

Real-World Examples of Interest on Reserves Policy in Action​

2008-2015: Low Interest on Reserves During Recovery: After the 2008 crisis, the Fed maintained the interest on reserves at 0.10-0.25% through 2014 while the federal funds rate target was 0-0.25%. The low rate on reserves made them unattractive and pushed banks to lend. This encouraged credit expansion and supported the recovery. By 2014, as the recovery progressed, the Fed began raising the interest on reserves in advance of raising the federal funds rate target. In December 2015, the Fed raised the federal funds target to 0.25%-0.50% and simultaneously raised interest on reserves to 0.25%. The fact that these rates moved together demonstrated that interest on reserves is not a separate policy lever but an integral part of the Fed's rate corridor system.

2016-2019: Normalization and Rate Hikes: As the economy recovered and the Fed believed unemployment had fallen below the natural rate, the Fed raised both the federal funds rate target and interest on reserves repeatedly. Each increase pushed up the interest rate on reserves, making reserves more valuable relative to loans. Banks faced higher returns on reserves and higher costs for risky lending. Credit growth moderated. Housing starts fell from a peak of 1.6 million units in 2016 to 1.2 million by 2019. This moderation of credit growth was exactly what the Fed intended—reducing the risk of overheating and limiting inflation.

2020-2022: Emergency Measures and Rapid Tightening: When COVID-19 hit in March 2020, the Fed cut the federal funds target back to zero and cut interest on reserves to zero as well. The Fed wanted to encourage maximum lending to prevent economic collapse. The Fed also resumed quantitative easing, buying $700 billion in the first week. Together, these measures flooded the banking system with reserves and made reserves unattractive, pushing banks to lend aggressively.

By 2021, inflation was rising. The Fed kept interest on reserves at zero even as it slowed its asset purchases. This policy was expansionary at a time the economy was overheating. Some economists argue that keeping interest on reserves at zero too long delayed the Fed's inflation response. In March 2022, as the Fed began raising rates, it raised the interest on reserves to 0.16%. By June 2022, it was 1.7%. By December 2022, it was 4.33%. This rapid tightening of rates via interest on reserves helped reduce the money supply and contributed to the sharp decline in inflation from 9.1% in June 2022 to 3.4% by December 2023.

How Banks Use Interest on Reserves in Decision-Making​

Banks do not use interest on reserves as the sole factor in lending decisions, but it is one important variable in a complex calculation.

A bank considering whether to lend $1 million faces several options. Option 1: Lend to a creditworthy business at 5% interest. The bank earns $50,000 per year if the loan is repaid, but faces default risk. The bank estimates a 2% probability of default, so expected return is $50,000 × 0.98 = $49,000.

Option 2: Hold $1 million in reserves at the Fed. If the Fed pays 4% interest, the bank earns $40,000 per year with zero risk. The bank also faces zero credit risk, zero operational risk, and zero regulatory risk. The money is completely safe.

From a risk-adjusted perspective, if the bank's cost of capital is 3%, the risk-free return of 4% on reserves looks attractive. The bank might choose to hold reserves rather than lend. If the Fed were paying only 2% on reserves, the loan at 5% with 2% default probability would be more attractive. The bank would prefer to lend.

This decision-making process, multiplied across thousands of banks and millions of lending decisions, determines how much credit is available in the economy. By adjusting the interest on reserves, the Fed influences this calculation and thereby influences credit growth.

The Mechanics of Paying Interest on Reserves​

How does the Fed actually pay interest on reserves? The mechanics are straightforward but important.

Banks hold deposits at the Federal Reserve's balance sheet. These deposits are liabilities of the Fed (money the Fed owes to banks) and assets of the banks. Each day, the Fed's accounting system credits interest to these accounts based on the interest rate and the balance held.

For example, if Bank of America holds $5 billion in reserves and the interest rate on reserves is 4.5%, the Fed credits $5 billion × 0.045 ÷ 365 = approximately $617,000 per day to Bank of America's reserve account. Over a year, this adds up to about $225 million. Bank of America can then use this interest income to pay shareholders, increase capital, or reduce the cost of deposits to customers.

Paying interest on reserves costs the Fed money. The Fed's income comes from the interest it earns on its asset portfolio (primarily the Treasury and mortgage securities it holds). During 2022-2023, as the Fed raised interest on reserves to 4.33% and held $7-8 trillion in assets, it was paying approximately $300+ billion per year in interest to banks. This was more than the interest income from the Fed's own securities in some periods, meaning the Fed ran an operating loss and did not remit profits to the Treasury.

This cost is important politically because it raises the question: Why is the Federal Reserve, a government institution, paying such large sums to private banks? Some argue that the Fed should not pay interest on reserves at all, that banks should be required to hold reserves without compensation. Others argue that paying interest is economically necessary to make reserves attractive relative to risky lending and to reduce pressure on the banking system.

Common Mistakes in Understanding Interest on Reserves​

Mistake 1: Confusing interest on reserves with interest on deposits. These are completely different. Interest on deposits is what you earn when you deposit money in a savings account at a commercial bank. That interest comes from the bank's lending profit. Interest on reserves is what the Fed pays banks on their reserve balances. You do not earn interest on reserves directly; only banks do. As a customer of a bank, you benefit indirectly if your bank earns more interest on reserves and uses that profit to offer higher deposit rates, but you are not earning the interest on reserves yourself.

Mistake 2: Assuming interest on reserves is always positive. In the United States, interest on reserves has never been negative, but some central banks have implemented negative rates (paying banks less than zero, effectively charging them to hold reserves). The European Central Bank and Swiss National Bank have experimented with negative rates on certain reserve categories. These negative rates are intended to penalize reserves and force banks to lend. They are controversial and face political resistance because they appear to transfer wealth from banks to borrowers.

Mistake 3: Believing interest on reserves is the primary tool the Fed uses to control monetary policy. Interest on reserves is important, but it is secondary to open market operations and forward guidance. The Fed primarily controls monetary conditions through buying and selling securities (open market operations), which directly adjusts reserve supply and the federal funds rate. Interest on reserves is complementary—it helps maintain the fed funds rate within the target corridor and provides an additional lever, but it is not the primary tool.

Mistake 4: Thinking all reserves earn the same interest. Technically, required reserves and excess reserves earned different rates from 2008-2014, though the difference was small. More importantly, not all central bank money earns interest. Currency in circulation (physical bills and coins) earns zero interest. Required reserves and excess reserves have earned the same rate since 2014. Banks also earn different rates depending on what type of reserves they hold—some international facilities pay different rates. The precise rate structure varies by central bank and by policy regime.

Mistake 5: Assuming banks will lend out all available reserves if interest on reserves is low. Even if the Fed pays zero interest on reserves, banks will not lend if they view borrowers as too risky or if they expect the economy to weaken. The 2008-2009 crisis demonstrated this—even as the Fed paid 0% interest on reserves and added massive quantities of reserves through quantitative easing, banks actually increased their reserve holdings and reduced lending. The reason was panic and fear, not economics. Behavioral factors and expectations matter as much as interest rate incentives.

Frequently Asked Questions​

What is the current interest rate on reserves?​

As of 2024, the Federal Reserve is paying between 5.33% and 5.58% on reserve balances (the upper bound of its target corridor for the federal funds rate minus 0.25%). This rate adjusts each time the Fed changes its target federal funds rate. The precise rate is published on the Federal Reserve's website under "Interest Rates Paid on Reserve Balances."

Does the interest on reserves come from taxpayers?​

Not directly. The Fed's income comes from the interest earned on its asset portfolio—the Treasury securities and mortgage-backed securities it holds. When the Fed earns more in interest on its assets than it pays in interest on reserves and operating expenses, it remits the profits to the Treasury. During 2022-2023, the Fed ran operating losses, meaning it paid more in interest on reserves than it earned on assets. These losses reduce the Fed's remittance to the Treasury, which effectively means less revenue for the government budget. Indirectly, this burden falls on taxpayers through lower government revenue or higher government borrowing.

Can the Fed pay negative interest on reserves?​

Yes, and some central banks have done so. The European Central Bank has charged banks for holding reserves, paying a negative rate to penalize reserves and encourage lending. The mechanics are the same as positive interest—the Fed simply credits a negative amount to reserve accounts. In practice, negative rates are controversial and face resistance from banks and politicians. The Fed has not implemented negative rates in the United States, partly because they would likely be challenged legally and politically.

How does interest on reserves affect the transmission of monetary policy?​

Interest on reserves is part of the transmission mechanism. When the Fed raises interest on reserves, holding money at the Fed becomes more attractive relative to lending, reducing credit expansion. When the Fed lowers interest on reserves, lending becomes more attractive relative to holding reserves, expanding credit. This channel works alongside the federal funds rate channel (higher short-term rates increase borrowing costs for banks, businesses, and households) and the asset price channel (Fed purchases of securities support asset prices and wealth).

Why can't the Fed just set interest on reserves to make borrowing free and stimulate the economy indefinitely?​

If the Fed paid very high interest on reserves (say, 20%), banks would hold all reserves and not lend. The money supply would not grow. Economic growth would stall. The Fed must balance the desire to stimulate with the need to avoid excessive inflation. If interest on reserves is too low, banks lend excessively and inflation rises. If too high, lending stalls and growth falls. The Fed tries to set interest on reserves at the level that supports full employment without inflation.

Is the interest paid on reserves the same as the federal funds rate?​

Not exactly. The federal funds rate is the rate at which banks lend to each other overnight. Interest on reserves is the rate the Fed pays on reserves. These are related (interest on reserves serves as the floor of the fed funds corridor), but they are not identical. The federal funds rate is determined by market supply and demand for overnight lending; interest on reserves is set administratively by the Fed.

Interest on reserves operates within a broader framework of monetary policy transmission and central bank operations. Understanding the full context requires knowledge of related mechanisms:

Summary​

Interest on reserves is the rate the Federal Reserve pays banks on their reserve balances. This tool influences banks' decisions about whether to hold reserves or lend them out, thereby controlling credit availability and the money supply. Higher interest on reserves makes reserves attractive, discouraging lending and tightening monetary conditions. Lower interest on reserves makes lending more attractive relative to holding reserves, encouraging lending and loosening monetary conditions. Interest on reserves became a policy tool in 2008 when the Fed flooded the banking system with reserves following the financial crisis. It is particularly important at the zero lower bound, when the Fed cannot lower the federal funds rate further but can still adjust interest on reserves to maintain policy control. Understanding interest on reserves reveals how central banks can influence lending and money supply growth through incentives rather than direct mandates, providing an elegant mechanism for monetary policy transmission.

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