Jai Kedia
The interest on reserves (IOR) framework, adopted by the Fed in the aftermath of the 2008 recession, is among the most dangerous of its “unconventional” modern monetary policy tools. Under this framework, the Fed pays billions of dollars to large banks to keep their deposits with the Fed. These deposits could have otherwise been used to fund capital investment in the private economy, and the Fed’s interest payments reduce the money it remits to the US Treasury. This framework also allows politicians to funnel mass spending programs through the Fed’s balance sheet without a proper appropriations process.
We have criticized the policy in-depth elsewhere, but this blog analyzes three of the ways the Fed defends its IOR framework, each of which ranges from obfuscating the truth to being demonstrably false.
1. The Fed claims that eliminating IOR would not save taxpayers any money. On its monetary policy FAQs webpage, the Fed defends this assertion in two ways. First, it insists that IOR payments are backed by equivalent asset holdings, such as US Treasuries, and that the interest received on these assets offsets interest losses paid to banks. This is a truly startling assertion, given that the Fed showed operating losses summing to nearly $200 billion in 2023 and 2024, driven almost entirely by interest payments made to large banks. Throughout this period, the Fed earned income on its holding of Treasury securities, but that income failed to offset these expenses. The Fed assures us that this “temporary outcome has been highly unusual and reflected the need to raise the policy rate to control inflation.” For this argument to work, we must believe that inflation will never occur in America again or, if it does, that the Fed will do nothing about it.
Second, the Fed claims that in the absence of IOR, banks would simply hold these Treasury securities directly rather than through the Fed. Even then, banks “would still earn interest paid by the government—both Treasury securities and reserves are government liabilities—and there would be no net effect on interest earned or paid by the government.” The problem with this argument is that the current system first funnels trillions of USD through an unelected government entity, whereas the alternative would have private firms make optimal investment decisions. Unlike the Fed, private banks have a limited appetite for government profligacy and will eventually cease to buy US bonds if they find no incremental value in them or if they do not believe in the government’s ability to pay back its debts. As a result, private banks will not endlessly monetize fiscal spending the way the Fed does, forcing greater fiscal austerity. Regardless, it is devious for the federal government to monetize its debt in this manner and then argue that people would have held the same amount of Treasuries anyway.
2. The IOR program gives the Fed better control over interest rates. Under its pre-2008 operating system, the Fed set a target for the interbank lending rate (FFR) and conducted small, directed open-market operations to influence that rate toward its target. Following the rapid expansion of its balance sheet under its quantitative easing program, the Fed transitioned from its old framework (a corridor system) to a new one (a floor system). Under this new system, the FFR was forced to its lowest possible value—the IOR rate. Any change to IOR would also calibrate the FFR to the same value without the need to affect open-market decisions. The Fed views this as a positive, but it has destroyed the private lending market between banks, the market where (prior to 2008) the FFR was set. The interbank lending market is a crucial private channel for banks to acquire funds from each other, and the market signals sent by such transactions have sharply reduced. Those wary of government overreach should be deeply concerned by an unelected government bureaucracy, the Fed, intervening so heavily in private lending decisions between banks.
Moreover, there is no evidence that better control over the FFR through the IOR has improved the Fed’s performance. The Fed did its job of influencing the economy for decades without using IOR. In fact, the Fed often takes credit for the Great Moderation, a period from the 1980s to the mid-2000s characterized by low and stable employment and inflation. The Fed was not authorized to use IOR until after the Great Moderation ended. And, with IOR available in its toolkit, the Fed was unable to prevent severe inflation in the aftermath of the COVID-19 pandemic. The evidence does not suggest that IOR is necessary for the Fed to achieve its monetary policy objectives.
3. Ending IOR would be economically harmful. The Fed has accumulated trillions of dollars in assets through quantitative easing by equivalently injecting cash into the financial sector. The only thing that is keeping those funds in check is the IOR payment to those banks. If, on the other hand, the Fed were to instantly remove that incentive (IOR payments) to hold on to this cash, banks would, in turn, use it to fund more loans to citizens. If done rapidly, this kind of massive increase in lending would likely spur demand for goods and services, which would result in increased inflation. Consequently, ending IOR without careful consideration could be inflationary, and it is wise to take this third defense seriously.
However, this defense is less an argument over principle and more a matter of execution. No serious opponent of IOR recommends eliminating the program overnight. As multiple Cato scholars have noted, IOR can only be ended once the Fed significantly reduces the size of its balance sheet. This decrease reverts the US back to a corridor interest rate system, at which point eliminating IOR is trivial since it does not bind the FFR. To decrease its balance sheet without being economically disruptive, the Fed must be given a suitable amount of time to revert its balance sheet. This goal is likely achievable within a 10–15 year period, roughly as long as it has taken the Fed to bloat its balance sheet to its current level.
Conclusion
People view the Fed as an all-powerful, all-knowing economic institution that controls various economic outcomes. As a result, most people, including members of Congress, are too likely to leave the Fed to its own devices, afraid that countering it would lead to bad economic outcomes. The truth is, the Fed is fallible. It suffers from the same bureaucratic deficiencies as other government agencies and from the same knowledge problems as all other groups of human beings. It should not be placed on a pedestal or exempt from questioning. If its programs are harmful, as IOR’s are, and if its arguments in defense of these programs are bad, as they are in IOR’s case, Congress should implement serious monetary policy reforms.
The author thanks Christian Kruse for his research assistance in preparing this article.