Interest on Reserves

The interest on reserves (or IOR) is the rate a central bank pays to banks on the reserve balances they hold in their accounts at the central bank. By setting this rate, the central bank influences how much banks are willing to lend and how they manage their liquidity, making IOR a powerful tool of monetary policy.

Why the Fed introduced interest on reserves

Before 2008, the Federal Reserve did not pay interest on reserves. Banks held reserves at the Fed because they were required to (under reserve requirements), not because the Fed offered any return. The Fed did not need to pay interest; law and regulation compelled banks to hold reserves.

The financial crisis changed this calculation. When the Fed cut interest rates to zero and began quantitative easing, it injected trillions of dollars in reserves into the banking system. If banks earned zero interest on those reserves, they would have no incentive to hold them. They would lend them out aggressively, potentially fueling an inflation spiral.

So in 2008, Congress authorized the Fed to pay interest on reserves. This allowed the Fed to offer banks a return on their reserve holdings, making it rational for them to hold reserves without lending them all away. Interest on reserves became a powerful new tool of monetary policy.

How interest on reserves works

When the Federal Reserve announces an interest rate on reserves (say, 1.50%), banks immediately adjust their behavior. Holding reserves at the Fed now yields 1.50%. Lending to customers, at say 2.50%, yields only 1.00% extra return (the spread above the Fed rate) plus credit risk. The Fed rate on reserves thus acts as a shadow policy rate, influencing the entire curve of interest rates in the economy.

If the Fed raises interest on reserves to 2.50%, lending to customers at 2.50% no longer makes sense (no spread, all risk). Banks hoard reserves. Lending contracts; credit tightens. The economy cools.

If the Fed lowers interest on reserves to 0.25%, hoarding reserves is uneconomical. Banks lend aggressively to earn higher returns. Credit expands; the economy booms.

The split: required versus excess reserves

For analytical purposes, it is useful to distinguish between two types of reserves:

Required reserves are the minimum banks must hold under reserve requirements. For decades, the Fed paid zero interest on these.

Excess reserves are any reserves above the minimum. In normal times, banks earn nothing on excess reserves and lend them out aggressively in the federal funds market.

In 2008, the Fed authorized interest on both types, but the rates and policy intent differ. (See interest-on-required-reserves and interest-on-excess-reserves for details.)

Interest on reserves as a tightening tool

Interest on reserves has become the primary tool of contractionary monetary policy. Instead of raising interest rates directly (there is often little room to do so when rates are already low), the Fed raises interest on reserves. Banks, now earning more on their reserve holdings, have less incentive to lend. Credit tightens. The money supply contracts.

This tool is especially powerful in a low-interest-rate environment. Even when the federal funds rate target is, say, 1.0%, the Fed can raise interest on reserves to 1.5%, making it uneconomical for banks to lend at rates below 2.0%. Effective tightening happens without the overnight rate moving.

Coordination with other tools

Interest on reserves is most effective when paired with other tools. For example:

• If the Fed raises interest on reserves but keeps open-market operations loose, banks may still have excess cash and lending may not contract.
• If the Fed raises interest on reserves and conducts quantitative tightening, both effects reinforce, tightening financial conditions sharply.

The Fed typically uses interest on reserves in conjunction with the federal funds rate target and forward guidance, creating a coherent signal about the direction of policy.

The zero-lower-bound problem revisited

When interest rates are at zero, the Fed has little room to cut further. But it can still lower interest on reserves to negative—that is, the Fed can charge banks to hold reserves. This is deeply unusual (few central banks have dared try it) but theoretically possible.

The downside is that if interest on reserves goes sufficiently negative, banks will demand to withdraw their reserves in cash. This is why central banks rarely push interest on reserves deep into negative territory.

See also