To get started, let me provide a quick refresher on bank reserves. In the U. The Federal Reserve Fed sets reserve requirements. Any holdings of reserves by DIs above their required levels are called excess reserves.
Traditionally before October , DIs held some excess reserves to deal with short-term cash flow uncertainties, such as unexpectedly large depositor withdrawals. However, up until recently excess reserves held with the Fed did not earn interest so DIs had an incentive to minimize their holdings of excess reserves. What is the magnitude of the recent buildup of excess bank reserves? When the Fed makes loans or buys assets, it creates both an asset on its balance sheet loans and securities and a deposit liability reserves.
During this period, deposits at the Fed, including both bank and the U. What is the link between this recent reserve buildup and monetary policy? The Federal Reserve responded aggressively to the financial crisis that emerged in the summer of To further stimulate the weakening economy during this first year of the crisis, the Federal Open Market Committee FOMC proceeded to lower the federal funds target rate in subsequent meetings.
Moving beyond these traditional tools of monetary policy, the Federal Reserve responded to the unusual stress in the financial markets with some new or unconventional tools.
The Term Auction Facility TAF — the first of a number of new liquidity and credit facilities designed to provide credit to financial institutions and financial markets — was introduced in December , and additional facilities were opened in March As a result of these actions, the composition of the Federal Reserve balance sheet began to change.
As shown in the top panel of Chart 2, the increase was originally driven by the credit program expansion but was later dominated by the Fed purchases of mortgage backed securities MBSs , agency related debt, and longer-term Treasury securities. As highlighted by Chairman Bernanke , in the challenging economic environment when these policy actions were undertaken, one dollar of longer-term securities purchase is likely to have a different impact on the economy than one dollar of lending to banks or one dollar of lending to support the commercial paper market.
Due to these differences in the impact of various lending types on the economy, it is not easy to summarize the policy stance by a single number such as the quantity of excess reserves. In October an important policy change took place — the Fed began paying interest on reserves. By paying an interest rate that fluctuates with the fed funds target its primary monetary policy tool 6 , the Federal Reserve has been able to change this incentive. The ability to pay interest on reserves has given the Federal Reserve better control over short-term interest rates, including the ability to raise the interest rate on reserves to provide an incentive for DIs to hold the funds at the Fed when the Fed funds target rate is increased.
With the unconventional policy impact coming from the asset side of the Fed balance sheet direct lending and asset purchases , the increase in excess reserves should be seen as a by-product rather than the focus of the policy action.
This contrasts sharply with conventional policy easing, when the Fed injects reserves to lower the fed funds rate and indirectly other interest rates when easing. Bank reserves for the system as a whole are determined by the central bank. One last important point I want to make is that the overall level of bank reserves in the banking system is determined by the Federal Reserve.
While it is true that an individual bank may decrease its excess reserves by making loans, that does not hold true for the banking system as a whole. No matter how many times the funds are lent out by the banks, used for purchases, etc. However, the link between policy actions and excess reserves is very different from what happens in a conventional policy response when the Fed was not paying interest on reserves.
For commercial banks, excess reserves are measured against standard reserve requirement amounts set by central banking authorities. These required reserve ratios set the minimum liquid deposits such as cash that must be in reserve at a bank; more is considered excess. Excess reserves may also be known as secondary reserves. Excess reserves are a safety buffer of sorts.
Financial firms that carry excess reserves have an extra measure of safety in the event of sudden loan loss or significant cash withdrawals by customers. This buffer increases the safety of the banking system, especially in times of economic uncertainty. The Federal Reserve has many tools in its monetary normalization toolkit. In addition to setting the fed funds rate, it now has the ability to change the rate of interest that banks are paid on required interest on reserves, or IOR and excess reserves interest on excess reserves, or IOER.
Prior to Oct. The Financial Services Regulatory Relief Act of authorized the Federal Reserve to pay banks a rate of interest for the first time.
The rule was to go into effect on Oct. Suddenly, and for the first time in history, banks had an incentive to hold excess reserves at the Federal Reserve. Proceeds from quantitative easing were paid out to banks by the Federal Reserve in the form of reserves , not cash.
However, the interest paid on these reserves is paid out in cash and recorded as interest income for the receiving bank. The interest paid out to banks from the Federal Reserve is cash that would otherwise be going to the U. The FRB reduced the reserve requirement ratios on net transaction accounts to zero percent, effective March 26, , in response to the economic fallout from the COVID19 pandemic.
Historically, the fed funds rate is the rate at which banks lend money to one another and is often used as a benchmark for variable rate loans. As a result, banks had an incentive to hold excess reserves, especially when market rates were below the fed funds rate.
In this way, the interest rate on excess reserves served as a proxy for the fed funds rate. The Federal Reserve alone has the power to change this rate, which increased to 0. Since then, the Fed has been using the interest on excess reserves to create a band between the fed funds rate and the IOER by setting it purposely below to keep their target rates on track.
For example, in December , the Fed raised its target rate by 25 basis points but only raised IOER by 20 basis points. This gap makes excess reserves another policy tool of the Fed. If the economy is heating up too fast, the Fed can shift up its IOER to encourage more capital to be parked at the Fed, slowing growth in available capital and increasing resiliency in the banking system.
So far, however, this policy tool has not been tested in a challenging economy. The first test to be watched and analyzed is now with the crisis, and the doubling of the excess reserves amount in a matter of nine weeks. Federal Reserve Board. Federal Reserve System. Accessed Sept. Federal Reserve Bank of St. Federal Reserve Board of Governors.
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