Interest on Reserves: A Review
of the Federal Reserve’s New
Monetary Policy Tool
Zamira Simkins
University of Wisconsin-Superior
Wisconsin Economics Association Annual Conference
November 9-10, 2012
Traditional Central Bank
Key objectives:
1. Low inflation
2. Sustainable
economic growth
3. Financial system
stability
4. Stable interest rates
5. Stable exchange
rates
Monetary policy tools:
1. Open Market
Operations
2. Discount rate
3. Reserve
requirement
Interest on Reserves
• Friedman (1960)
▫ Opportunity cost of holding RR
▫ IOR = market interest rate
• Goodfriend (2002)
▫ IOR as a monetary policy tool
Interest Rate Policy Regimes
A. Open Market Operations
i
Disc.
rate
i
Supply
Supply
Disc.
rate
FFR1
FFR2
B. Interest on Reserves
FFR1
Demand
Q1 Q2
Reserves
Demand
IOR
Q1
Q2IOR Reserves
Benefits of IOR Regime
• Enables the Fed to conduct monetary policy
even when interest rates are near zero
• Enables the Fed to pursue additional monetary
policy objectives
• Allows the Fed to inject liquidity (i.e. reserves) in
financial markets
Fed and IOR
• Fed had no legal authority to pay IOR prior to
2008
• Financial Services Regulatory Relief Act (2006):
IOR effective October 1, 2011
• Emergency Economic Stabilization Act (2008):
IOR effective October 1, 2008
Key Interest Rates in 2008
2.50
Interest rate, %
2.00
1.50
1.00
0.50
0.00
Effective
Federal
Funds Rate
Discount
Rate
Interest on
Excess
Reserves
Interest on
Required
Reserves
Key Interest Rates after 2008
0.80
0.70
Interest rate, %
0.60
Effective
Federal Funds
Rate
0.50
0.40
Discount
Rate
0.30
0.20
0.10
0.00
IOR (Excess
& Req)
Liquidity Crisis
• Liquidity crisis is a state in which financing
economic activities, either via borrowing or
selling of financial instruments, becomes
difficult
• Liquidity crisis indicators:
▫ Declining prices of financial assets
▫ Downgrading of securities ratings
▫ Increasing TED spread
T-Bill - Eurodollar (TED) Spread
7.00
6.00
5.00
4.00
3.00
2.00
1.00
0.00
3M T-Bill Rate
3M LIBOR
TED Spread
IOR and Liquidity
Bill $
3,000
Monetary Base
M1 Stock
2,500
2,000
Dec 2008
1,500
1,000
500
0
IOR and Liquidity
Bill. $
1,800
1,600
1,400
1,200
1,000
800
600
400
200
0
Excess Reserves
Interest on Excess Reserves
%
1.00
0.90
0.80
0.70
0.60
0.50
0.40
0.30
0.20
0.10
0.00
Conclusion
• US liquidity conditions are still tight
• Between January 2007 and December 2011,
excess reserves grew from $1.5 billion to
$1.5 trillion
• Interest on excess reserves is reducing the
opportunity cost of not lending