Interest on Excess Reserves

The interest on excess reserves (or IOER) is the rate a central bank pays on reserve balances held by banks above their minimum reserve requirements. By varying this rate, the central bank encourages or discourages banks from holding surplus reserves rather than lending them out, making IOER a direct lever on money creation and credit expansion.

Why excess reserves matter

A bank facing a choice between holding an excess reserve earning 1.50% at the Fed or lending it at 2.00% will lend. The extra 0.50% (called the spread) is the bank’s profit. But if the Fed raises the excess-reserves rate to 2.50%, suddenly holding reserves earns more than lending. The bank hoards the reserve.

By controlling the excess-reserves rate, the Fed can make reserve-hoarding attractive or unattractive, which directly controls the pace of lending and money creation.

The mechanics during quantitative easing

During the 2008 financial crisis and subsequent recovery, the Fed kept the excess-reserves rate modest while injecting trillions of dollars in new reserves through quantitative easing. The goal was to force banks to lend out the new money rather than hoarding it.

A low excess-reserves rate said, “Holding reserves is unrewarding; please lend.” This encouraged credit expansion and supported the recovery. As the economy strengthened, the Fed gradually raised the excess-reserves rate in tandem with interest-rate hikes, signaling a shift toward tightening.

IOER and the federal funds market

The excess-reserves rate acts as a floor for the federal funds rate (the overnight rate at which banks lend reserves to each other). If a bank can earn 1.50% by holding reserves at the Fed, it will not lend reserves to another bank overnight for less than 1.50%. This creates a lower bound on the federal funds rate.

The Fed uses this relationship as part of its toolkit. By setting the excess-reserves rate strategically (usually 0.25% above the federal funds rate target), the Fed creates a band in which the actual rate will trade, giving it tight control over short-term money rates.

Modern relevance after reserve requirements end

When the Fed eliminated reserve requirements in March 2020, some thought the excess-reserves rate would become obsolete. After all, with no requirement, there is no distinction between “required” and “excess.”

In practice, the Fed has maintained interest-on-reserves schedules that effectively perform the same function. The Fed still sets rates that influence banks’ incentives to hold reserves versus lend, even without a formal reserve minimum. This reflects a lasting insight: the ability to pay interest on reserves is a powerful policy tool, reserve requirements or not.

Negative excess-reserves rates

Theoretically, the Fed could set IOER negative—charging banks to hold excess reserves. This would force reserves back into the lending market and expand credit aggressively. Some central banks in Europe and Asia have experimented with negative rates, though with mixed results.

The Fed has been reluctant to go deeply negative, worrying that banks would withdraw reserves in cash and that the financial system would destabilize. But the possibility remains an option if deflation or severe credit contraction threatens.

See also