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FAQs about Interest on Reserves and the Implementation of Monetary Policy
1. How will the payment of interest on reserve balances be administered?
Detailed answers to questions about how the payment of interest on reserve
balances will be administered and interest payments calculated can be found
on the the Federal Reserve System Reporting and Reserves
What’s most critical for the implementation of monetary policy is that
interest will be paid on the excess balances depository institutions hold,
i.e., the amount above the quantity of balances needed to satisfy their reserve
requirements (which will also be remunerated), and their clearing balances
(which will continue to earn implicit interest in the form of earnings credits).
2. How will authority to pay interest on reserves be helpful
in implementing monetary policy?
The Open Market Trading Desk (Desk) at the Federal Reserve Bank of New York
is authorized to arrange open market operations in accordance with the operating
directive of the Federal Open Market Committee (FOMC), which sets a target
for the federal funds rate. Without authority to pay interest on reserves,
from time to time the Desk has been unable to prevent the federal funds rate
from falling to very low levels. With the payment of interest on excess
balances, market participants will have little incentive for arranging federal
funds transactions at rates below the rate paid on excess. By helping
set a floor on market rates in this way, payment of interest on excess balances
will enhance the Desk’s ability to keep the federal funds rate around
the target for the federal funds rate.
3. Why is the payment of interest on reserve balances, and on
excess balances in particular, especially important under current conditions?
Recently the Desk has encountered difficulty achieving the operating target
for the federal funds rate set by the FOMC, because the expansion of the Federal
Reserve’s various liquidity facilities has caused a large increase in
excess balances. The expansion of excess reserves in turn has placed
extraordinary downward pressure on the overnight federal funds rate. Paying
interest on excess reserves will better enable the Desk to achieve the target
for the federal funds rate, even if further use of Federal Reserve liquidity
facilities, such as the recently announced increases in the amounts being offered
through the Term Auction Facility, results in higher levels of excess balances.
4. What other methods does the Federal Reserve have at its disposal
to facilitate the implementation of monetary policy when the use of its various
liquidity facilities contributes to high levels of excess balances?
Initially, the Federal Reserve was able to prevent excess balances from expanding
as the use of its new liquidity facilities grew by reducing other assets it
held on its balance sheet, notably holdings of U.S. Treasury securities. But
many of its remaining holdings of Treasury securities are now dedicated to
support the Term Securities Lending Facility and other programs.
More recently, the Supplemental Financing Program has been invaluable in helping
to limit the growth in excess balances as use of the Federal Reserve’s
liquidity programs has continued to expand. Under the Supplemental Financing
Program the U.S. Treasury has issued Treasury bills in the market and deposited
the proceeds in an account at the Federal Reserve.
But payment of interest on excess balances could enable the Desk to achieve
the operating target for the federal funds rate even without further use of
these other measures and in principle with any level of excess balances. And
in addition to remunerating excess balances, the Federal Reserve is exploring
other methods to manage reserve levels for the purpose of implementing monetary
policy with its authority to pay interest on reserves.
5. Does paying interest on excess balances constitute a change
in monetary policy?
No. The stance of monetary policy continues to be set by the target for the
overnight federal funds rate established by the FOMC. Paying interest
on excess balances just makes it easier for the Desk to implement the target
federal funds rate chosen by the FOMC.
6. How will the levels of interest rates paid on excess balances
be chosen to facilitate the implementation of monetary policy?
The Board of Governors has set the initial rate to be paid on interest on
excess balances at the lowest target federal funds rate for a reserve maintenance
period less 75 basis points. However, the Board is prepared to adjust
this spread as needed to help the Desk achieve the operating target for the
average federal funds rate set by the FOMC, based on experience and in response
to evolving market conditions.
7. Is paying interest on excess balances inflationary?
No. The payment of interest on excess balances will permit the Desk
to keep the federal funds rate closer to the target even as the Federal Reserve
provides the necessary liquidity to support financial stability through its
liquidity facilities. The federal funds rate target is set at the level
that is appropriate in light of the Federal Reserve’s objectives of maximum
employment and price stability.
8. Will other elements of the framework for implementing monetary
policy be affected by the payment of interest on reserve balances?
The Board of Governors has not made any determination about changing required
reserve ratios or other elements of the reserve accounting framework. However,
the Federal Reserve will continue to analyze different approaches to employing
authority to pay interest on reserves as part of a more fundamental restructuring
of the framework for implementing monetary policy over the longer run.