Will Paying Interest on Reserves Endanger the Fed’s Independence?

Abstract

The Federal Reserve started to pay interest on bank reserves during the Great Recession in 2008. These payments set an effective floor to the fed funds rate and allowed the Fed to determine shortterm interest rates with great precision. Together with a greatly expanded balance sheet, the interest rate paid on reserves became the primary monetary policy tool by which the Fed implemented its monetary policy decisions during the last decade. But the payment of interest on bank reserves had several side effects that were perhaps not fully recognized at the time that the decision was made. By paying interest on reserves, the Fed not only contributed significantly to the earnings of its member banks, but also influenced the size of the income transfers that the Fed regularly makes to the Treasury. Consequently, the effects of monetary policy actions became directly linked to the operating revenues of the federal government and by this to fiscal policy. As the Fed increasingly influences important fiscal variables, such as the size of the federal deficit, there looms the danger that politicians will attempt to influence the monetary policy actions of the Fed, thereby endangering the independence of the institution.