The Federal Reserve should stop paying interest on reserves

In the aftermath of the financial crisis of 2008 the Federal Reserve took many extraordinary measures to prop up the financial system.  Among these was the decision to pay interest on funds held in reserve at the Fed by member banks as authorized by the Emergency Economic Stabilization Act of 2008.

This policy may have been prudent at the height of the crisis, but now, more than ten years later, the banks have returned to stability and this support is no longer needed.

In the almost one hundred years before the 2008 crisis the Fed has only paid interest on reserves very recently for only two short months, first after the 9/11 attacks and second at the beginning of the crisis in 2007.  Despite two world wars, a Great Depression, periods of strong growth, and other gyrations of the economy and financial system no justification was found for paying such interest during these historic events.

Banks have been clamoring for interest on reserves since the beginning of the Fed.  But, there are no good reasons to pay interest on reserves outside of crisis periods.  Reserves held at the Fed and elsewhere are created by the Fed itself as so called “high-powered” money, and in a sense belongs to the Fed. 

Early in the crisis the interest rate paid on reserves was only 0.25%, but now the rate has risen to 2.35% [1].  In June 2019 the total reserves held at the Fed totaled $1577B [2].  At straight interest that equates to $37B in interest paid for the year.  This is an enormous amount of money that the banks have done nothing to earn.

The interest paid is not just a Fed accounting mechanism.  Rather, these are real funds that would otherwise have been deposited with the US Treasury and been available for Congress to spend.  These funds are paid on a kind of autopilot mode without annual Congressional appropriations authorization. So, they have and will continue to grow without any Congressional appropriation or additional authorization.  

If the banks still need this money, then there is something fundamentally wrong with the banks that needs to be resolved.  But, it the banks have recovered, as is evidenced by their strong profitability, then they no longer have need of these funds and Congress should rescind the payment of interest on reserves.

[1] https://www.federalreserve.gov/monetarypolicy/reqresbalances.htm

[2] https://www.federalreserve.gov/releases/h3/current/

  

No new currency is needed to pay interest on fiat currency

Often one hears claims that fiat currencies are intrinsically inflationary and ever expanding because more currency is needed in the future to pay the interest on current fiat currency.  At first glance this seems reasonable, but this is actually a specious argument.

A simple example will make this clearer.  Consider a case where an amount of currency has been created through loans, but no more will be created in the future.  Thus the money supply is constant.  Furthermore, let's assume that only the interest on these loans is paid by the borrowers so that the loans themselves will never be paid back, and the money supply will stay constant.

In this case, the interest to pay on the loans must come from the available money supply, which we've already said is fixed in amount.  So, if the claims about needing an ever expanding money supply are correct then this system will quickly grind to a halt as no more currency is being created.  For this to happen the banks would need to hoard all the interest that they receive and never pay it out in any way into the economy.  By doing this the banks would be creating a deflation in the economy as the amount of currency in circulation is ever decreasing as the interest is paid to the banks year after year.  In effect, the banks are increasing their reserves by this hoarding action.

In reality, the banks that receive interest on their loans also pay out those funds in the form of salaries, costs, and profits.  So, the interest payments that come into the bank also go out in the same amount.  This is where the funds for paying the interest comes from.  The interest payments simply circulate in the economy with payments made to the banks as interest and the funds spent back into the economy by the banks.

In a real banking system, as we have in the US, banks are required to hold reserves by regulation at the Federal Reserve.  Moreover, the Fed provides these reserves to the banks. The banks could increase or decrease their reserves as previously mentioned and this would change the money supply in circulation.  But banks have little incentive to increase their reserves as this would reduce the amount they can lend and the resulting interest payments they receive.  Changes in the money supply are closely monitored by the Fed and it acts through its open market operations to influence the money supply by buying or selling assets in the market.  So, there are always funds to pay interest on fiat currency.  The amount of funds may vary according to reserves held by banks and the Fed actions, but nothing is specifically expansionary in the money supply due to interest payments alone.