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Interest on Reserves: A Review of the Federal Reserve’s New Monetary Policy Tool

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: Low inflation Sustainable economic growth

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Interest on Reserves: A Review of the Federal Reserve’s New Monetary Policy Tool

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  1. 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

  2. Traditional Central Bank Key objectives: • Low inflation • Sustainable economic growth • Financial system stability • Stable interest rates • Stable exchange rates Monetary policy tools: • Open Market Operations • Discount rate • Reserve requirement

  3. Interest on Reserves • Friedman (1960) • Opportunity cost of holding RR • IOR = market interest rate • Goodfriend (2002) • IOR as a monetary policy tool

  4. Interest Rate Policy Regimes • A. Open Market Operations • B. Interest on Reserves i i Supply Supply Disc. rate Disc. rate FFR1 FFR1 Demand Demand FFR2 IOR Reserves Q1 Q2 Q1 Q2IOR Reserves

  5. 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

  6. 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

  7. Key Interest Rates in 2008

  8. Key Interest Rates after 2008

  9. 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

  10. T-Bill - Eurodollar (TED) Spread

  11. IOR and Liquidity

  12. IOR and Liquidity

  13. 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

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