9. The authority to pay interest on reserves is likely to be an important component of the future operating framework for monetary policy. For example, one approach is for the Federal Reserve to bracket its target for the federal funds rate with the discount rate above and the interest rate on excess reserves below. Under this so-called corridor system, the ability of banks to borrow at the discount rate would tend to limit upward spikes in the federal funds rate, and the ability of banks to earn interest at the excess reserves rate would tend to contain downward movements. Other approaches are also possible. Given the very high level of reserve balances currently in the banking system, the Federal Reserve has ample time to consider the best long-run framework for policy implementation. The Federal Reserve believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which impose costs and distortions on the banking system.
What costs? In June 1993 The Federal Reserve published a paper on this topic called Reserve Requirements: History, Current Practice, and Potential Reform by Joshua N. Feinman.
Reserve requirements are not costless, however. On the contrary, requiring depositories to hold a certain fraction of their deposits in reserve, either as cash in their vaults or as non-interest-bearing balances at the Federal Reserve, imposes a cost on the private sector equal to the amount of forgone interest on these reserves—or at least on the fraction of these reserves that banks hold only because of legal requirements and not because of the needs of their customers.The higher the level of reserve requirements, the greater the costs imposed on the private sector; at the same time, however, higher reserve requirements may smooth the implementation of monetary policy and damp volatility in the reserves market.
The Federal Reserve could resolve this policy dilemma by paying interest on required reserves, or at least on the part of these reserves that banks would not hold were it not for legal requirements. Paying an explicit, market-based rate of return on these funds would effectively eliminate much of the costs of reserve requirements without jeopardizing the stable demand for reserves that is needed for open market operations and for the smooth functioning of the reserves market.
In general, I am very much in favor of reducing taxes. However, these companies should probably be paying something extra for their free put options, and yet the current tone of the federal reserve is still geared towards finding ways to help banks get away with paying even less. Furthermore, the consequence of 0% reserve requirements are rather interesting, as someone reading this primer written by the New York Fed in May 2007 might figure out:
Reserve requirements affect the potential of the banking system to create transaction deposits. If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit. If the borrower then writes a check to someone who deposits the $90, the bank receiving that deposit can lend out $81. As the process continues, the banking system can expand the initial deposit of $100 into a maximum of $1,000 of money ($100+$90+81+$72.90+...=$1,000). In contrast, with a 20% reserve requirement, the banking system would be able to expand the initial $100 deposit into a maximum of $500 ($100+$80+$64+$51.20+...=$500). Thus, higher reserve requirements should result in reduced money creation and, in turn, in reduced economic activity.
They go on to explain that taking these calculations to their logical extreme is incorrect, since time deposits and savings accounts don't have these requirements and yet don't multiply as much as a zero percent reserve requirement would imply. Still, it is rather worrisome that the Federal Reserve is thinking of switching the whole banking system onto a system that would support extremely large money multipliers*. The primer also mentions paying interest rate on reserves.
The Fed has long advocated the payment of interest on the reserves that banks maintain at Federal Reserve Banks. Such a step would have to be approved by Congress, which traditionally has been opposed because of the revenue loss that would result to the U.S. Treasury. Each year the Treasury receives the Fed's revenue that is in excess of its expenses. The payment of interest on reserves would, of course, be an additional expense to the Fed.
Scott Sumner (and presumably other economists) have often wondered why the Fed started paying reserves on interest in the middle of the crisis since it effectively tightened monetary policy by reducing the bank's incentives to lend even further. The Federal Reserve might have realized that during a time of crisis they would be given whatever they wanted to fix the crisis, so they asked for something they've wanted for a long time even though they could have done more to stimulate the economy with quantitative easing than with their long ability to pay interest on reserves.
*The formula for calculating the money multiplier is (1+c)/(c+R). c is the rate at which people hold cash instead of depositing it. If everyone deposited their cash and reserve requirements were zero, then the money multiplier would be infinite.