What Is Interest on Reserve Balances?
Interest on reserve balances refers to the interest paid by a central bank to depository institutions on the funds they hold in their accounts at the central bank. This tool is a key component of modern monetary policy, allowing the central bank to influence short-term interest rates and manage the supply of money in the economy. The Federal Reserve, the central bank of the United States, uses the interest on reserve balances (IORB) rate as a primary tool to guide the federal funds rate toward its target range, thereby supporting its macroeconomic objectives of maximum employment and price stability. These balances include both required reserves and any excess reserves that banks choose to hold.
History and Origin
For decades, many central banks around the world had the authority to pay interest on reserves, but the Federal Reserve did not. The idea of paying interest on bank reserves gained academic support from economists like Milton Friedman, who argued it could improve monetary policy by making it easier to hit short-term interest rate targets and reduce distortions associated with holding non-interest-bearing reserves.20
Legislation granting the Federal Reserve this authority, the Financial Services Regulatory Relief Act of 2006, initially set an effective date of October 1, 2011.19 However, the onset of the 2008 financial crisis prompted Congress to accelerate this timeline. The Emergency Economic Stabilization Act of 2008 advanced the effective date to October 1, 2008.18 This change was crucial, as it provided the Federal Reserve with an additional tool to manage interest rates during a period of significant stress in financial markets, especially as its balance sheet expanded due to various liquidity facilities.17 Since July 29, 2021, the previous separate rates for interest on required reserves (IORR) and interest on excess reserves (IOER) were replaced with a single, unified interest rate on reserve balances (IORB).16
Key Takeaways
- Interest on reserve balances is the rate paid by a central bank on funds held by commercial banks in their accounts at the central bank.
- It is a fundamental tool for implementing monetary policy, influencing short-term interest rates in the broader economy.
- By adjusting the IORB rate, the Federal Reserve can encourage or discourage banks from lending their excess funds, thus affecting the federal funds rate.
- The authority to pay interest on reserve balances was granted to the Federal Reserve in 2006 and accelerated in 2008 during the financial crisis.
- The IORB rate helps to establish a floor for the federal funds rate in the money markets.
Formula and Calculation
The calculation for interest on reserve balances is straightforward. For each day, the interest earned is determined by multiplying the bank's end-of-day balance held at the Federal Reserve by the prevailing interest rate on reserve balances (IORB rate) for that day. The total interest for a maintenance period (typically two weeks) is the sum of the daily interest calculations.15
The formula can be expressed as:
Where:
- (\text{End-of-Day Balance}) represents the total reserve balances held by the depository institution at the close of a given day.
- (\text{IORB Rate}) is the annual interest rate on reserve balances, expressed as a decimal, set by the Board of Governors of the Federal Reserve.
- (\text{N}) is the number of days in the reserve maintenance period.
Interpreting the Interest on Reserve Balances
The interest rate on reserve balances is a key indicator of the Federal Reserve's stance on monetary policy. When the Federal Reserve raises the IORB rate, it makes holding reserves more attractive for depository institutions. This tends to encourage banks to hold onto their reserves rather than lending them out in the federal funds market at lower rates. Consequently, it puts upward pressure on the federal funds rate, which is the benchmark for many other short-term interest rates in the economy.14
Conversely, lowering the IORB rate makes holding reserves less appealing, incentivizing banks to lend more. This increases the supply of funds in the interbank market, pushing the federal funds rate down. The IORB rate acts as a "floor" for the federal funds rate, as banks generally would not lend funds in the interbank market below what they can earn risk-free by holding balances at the Federal Reserve.13
Hypothetical Example
Consider a commercial bank, "Bank A," holding $500 million in reserve balances at the Federal Reserve at the end of a particular day. If the Federal Reserve has set the interest rate on reserve balances (IORB rate) at 4.4% (effective July 31, 2025, as an example),12 Bank A would earn interest on these balances.
To calculate the daily interest, first convert the annual IORB rate to a daily rate:
Daily IORB Rate = (4.4% / 365 \text{ days}) = (0.044 / 365) (\approx 0.000120548)
Daily Interest Earned by Bank A = ( $500,000,000 \times 0.000120548 )
Daily Interest Earned by Bank A = ( $60,274 )
Over a typical two-week reserve maintenance period, the total interest earned would be the sum of these daily calculations. This payment provides a direct incentive for banks to hold balances at the Federal Reserve, which in turn helps the Federal Reserve manage the level of liquidity in the financial system and control the federal funds rate.
Practical Applications
The interest on reserve balances plays a pivotal role in the conduct of monetary policy by the Federal Reserve. Its practical applications include:
- Interest Rate Control: The primary use of interest on reserve balances is to influence the federal funds rate. By adjusting the IORB rate, the Federal Reserve can effectively set a floor for this overnight interbank lending rate, steering it towards its desired target. This is particularly effective in an environment of abundant reserves.11
- Liquidity Management: Paying interest on reserves allows the Federal Reserve to maintain a large balance sheet and provide ample liquidity to the banking system without losing control over short-term interest rates. This contrasts with previous regimes where open market operations were the primary tool for reserve management.10
- Financial Stability: During times of financial stress, the ability to pay interest on reserves provides the Federal Reserve with flexibility. It allows the central bank to inject substantial liquidity into the system to support financial markets, while still being able to manage short-term rates.9 This was critical during the 2008 financial crisis.
- Reduced Volatility: By establishing a clear floor for the federal funds rate, interest on reserve balances helps reduce volatility in overnight money markets, contributing to more predictable interest rate environments for banks and other financial participants.8
Limitations and Criticisms
While interest on reserve balances is a powerful monetary policy tool, it is not without limitations or criticisms.
One concern raised is that paying interest on reserves could be viewed as a subsidy to the financial sector.7 Critics argue that these payments reduce the profits that the Federal Reserve remits to the U.S. Treasury, which otherwise could help alleviate the federal deficit.6
Another criticism, particularly during periods of low interest rates or when the policy was first implemented, was that it might disincentivize banks from lending. Some economists have suggested that higher interest on reserve balances could lead banks to substitute holding safe, interest-earning reserves for making loans, potentially making it harder for businesses to access credit.5 This perspective implies that it could hinder economic activity rather than stimulate it.
Furthermore, some argue that paying interest on reserves allows central banks to maintain excessively large balance sheets, potentially expanding their influence on credit allocation within the economy.4 The policy has also been scrutinized for its potential impact on the interbank lending market, as banks might have less incentive to lend reserves to each other when they can earn a guaranteed rate from the central bank.3
Interest on Reserve Balances vs. Federal Funds Rate
While closely related and often discussed together, interest on reserve balances (IORB) and the federal funds rate are distinct concepts in monetary policy.
The interest on reserve balances (IORB) is an administered rate set directly by the Federal Reserve. It is the interest rate paid to depository institutions on the funds they hold in their accounts at the Federal Reserve. This rate acts as a key policy lever.
The federal funds rate is a market-determined interest rate. It is the target rate at which commercial banks lend excess reserves to each other overnight, on an uncollateralized basis. This rate fluctuates based on supply and demand in the federal funds market.
The primary difference lies in their nature: IORB is a policy tool set by the central bank, whereas the federal funds rate is a market outcome that the central bank influences using its policy tools, including IORB. The Federal Reserve uses the IORB rate to guide the federal funds rate towards its desired target range. For instance, an increase in the IORB rate typically pulls the federal funds rate higher, as banks demand a higher rate for lending their reserves to other banks when they can earn more by holding them at the Federal Reserve.2
FAQs
Why does the Federal Reserve pay interest on reserve balances?
The Federal Reserve pays interest on reserve balances primarily to control the federal funds rate and maintain financial stability. By adjusting this rate, the Federal Reserve can influence the incentives for banks to lend their excess reserves, thereby guiding overall short-term interest rates in the economy. It also helps manage the level of liquidity in the banking system.
Does the interest on reserve balances affect consumers?
Yes, indirectly. Changes in the interest rate on reserve balances influence the federal funds rate, which serves as a benchmark for many other interest rates in the economy. This includes rates on consumer loans, mortgages, and savings accounts. When the IORB rate rises, borrowing costs for consumers may eventually increase, and savings rates might improve. The opposite tends to occur when the IORB rate falls, impacting overall economic stability.
Is interest on reserve balances part of quantitative easing?
Interest on reserve balances is distinct from quantitative easing (QE), though both are tools used by central banks. QE involves large-scale asset purchases by a central bank to inject liquidity into the financial system and lower long-term interest rates. The authority to pay interest on reserves, especially on excess reserves, became particularly important during and after periods of QE, as it allowed the Federal Reserve to manage short-term rates even with a vast supply of reserves in the banking system.1