financial institutions in September 2008 caused a great degree of instability in the financial system.
Other than those two months, excess reserves were less than 10% of total reserve holdings, because depository institutions had an incentive to minimize noninterest-bearing excess reserves held at the Fed. Those occurred when the Fed provided unusual levels of reserves to depository institutions in September 2001 following the terrorist attacks and in August 2007 at the onset of the global financial crisis. This relationship was typical for the past 50 years when the Fed did not pay interest on reserves with only two exceptions. In 2007, required reserves averaged $43 billion, while excess reserves averaged only $1.9 billion. …pay interest on required reserve balances (that is, balances held to satisfy depository institutions' reserve requirements) and on excess balances (balances held in excess of required reserve balances and clearing balances). Under the 2006 Act, Federal Reserve Banks were directed to Required and excess reserves before and after the crisis In the rest of this response, I will focus on the details of these interest rate payments and discuss why they were implemented. To counteract these pressures, on October 6, 2008, the Federal Reserve Board announced that it would begin paying interest on depository institutions’ reserve balances.
4 This was important for monetary policy because the Federal Reserve’s various liquidity facilities 5 initiated during the financial crisis caused upward pressure on excess reserves and placed downward pressure on the Federal funds rate. However, during the financial crisis, the effective date was moved up by three years through the Emergency Economic Stabilization Act of 2008.
The legislation was supposed to go into effect beginning October 1, 2011. Congress in 2006īefore the crisis, Congress passed the Financial Services Regulatory Relief Act of 2006 authorizing the Federal Reserve to begin paying interest on reserves held against certain types of deposit liabilities. For example, the Bank of England has paid interest on reserves since 2009, and the European Central Bank has had this authority from its inception in 1999. Globally, a number of central banks have the authority to pay interest on reserves held against deposits. In the United States, paying interest on reserve balances was designed to broaden the scope of the Fed’s lending programs to address conditions in credit markets while maintaining the federal funds rate close to the target established by the Federal Open Market Committee (FOMC), the Fed’s monetary policy decisionmakers. Total reserve balances held at the Fed include required reserves and any excess reserves that depository institutions choose to hold on top of the required reserves. This new policy is especially important now that the Fed has been holding more than $1 trillion dollars in total reserves from depository institutions for the past three years. However, the Fed didn’t have the authority to pay this kind of interest until 2008. This proposal was intended to improve monetary policy by making it easier to hit short-term interest rate targets. Four decades ago, Milton Friedman recommended that central banks like the Federal Reserve pay interest to depository institutions on the reserves they are required to hold against their deposit liabilities.
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