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Yellen comment highlights simmering debate over return on excess reserves

Federal Reserve Chair Janet Yellen testifies at a Senate Banking, Housing and Urban Affairs Committee hearing on "Semiannual Monetary Policy Report to Congress" on Capitol Hill in Washington, February 24, 2015. REUTERS/Kevin Lamarque

Federal Reserve Chairwoman Janet Yellen's response to a question during her semi-annual report to Congress about excess reserves went largely unnoticed. But it actually hints at an important debate.

During the hearing Tuesday, Senator Pat Toomey (R-PA) probed Yellen about the central bank's plan to increase interest on excess reserves, as part of its process to normalize monetary policy. Yellen responded, “Well, remember that first of all, we will be paying banks rates that are comparable to those that they can earn in the marketplace, so those payments don't involve subsidies to banks.”

However, the Fed pays banks well above market rates, as measured by a closely-watched benchmark.

Banks yield a return of 25 basis points (0.25%) to keep their excess cash balances overnight at the Fed.  This is called interest on excess reserves (IOER). The General Collateral (GC) Repo rate is a comparable overnight “market” rate, and it is currently well below 25 basis points, according to data from DTCC Solutions.

The rate the Fed pays banks vs the market rate
The rate the Fed pays banks vs the market rate

The chart above demonstrates that IOER is a multiple of the historical GC Repo rate, and as of Monday it was more than 4 times as high.  It’s in the Fed’s best interest to maintain this opportunity cost.

"She probably shouldn't have said comparable," says Joshua Feinman, chief economist and managing director of Deutsche Asset Management. "They're probably anticipating these excess reserve rates will form a ceiling on money market rates."

Keeping money at the Fed is deemed to be risk-free, and this safe storage usually comes at a premium. However, in the case of interest on excess reserves, the Fed pays a higher rate despite being the safest name in town*.

Yellen is not the first Fed chairperson to give this response to the Senate. In February 2013, Ben Bernanke responded to Senator Bob Corker’s (R-TN) assertion that the Fed is subsidizing banks with its payments of IOER. Bernanke said (emphasis ours), “We’ll be paying market rates. We’ll be paying exactly what they would be getting in the repo market, the commercial paper market. There’s no subsidy involved.”

Banks haven't always received interest on excess reserves. When the Federal Reserve System was created, member banks were required to keep some cash at the Fed to ensure solvency. But banks did not get paid interest on these reserves.

Yet, in 2006, lawmakers agreed to make interest payments on the money in reserve at the Fed. This was slated to go into effect in 2011. But the start date was moved up to October 2008 as a result of the financial crisis.

Before 2008, excess reserves were at a minimum, as there was no incentive to keep money parked at the Fed. As soon as the Fed started paying interest at above-market rates, the money held in excess reserves skyrocketed.

Excess reserves in millions
Excess reserves in millions

Excess reserves have continued to rise through each quantitative easing iteration to $2.6 trillion, as of January 2015. At this level, the Fed pays banks $6.5 billion per year to stash their cash at the Fed.

The Fed explained the reason for paying interest on bank reserves in an October 2008 press release. It said this would permit it to expand its balance sheet and more closely control the important federal funds rate.

“The payment of interest on excess reserve balances will give the Federal Reserve greater scope to use its lending programs to address conditions in credit markets while also maintaining the federal funds rate close to the target established by the Federal Open Market Committee," the press release said.

Once interest rates rise, the Fed will have to maintain higher interest on excess reserve rates to make sure that this money doesn’t just flow out into the system. Since the Fed must remit all its profits to the Treasury, this increasing expense of IOER will lessen future Fed payments to the taxpayer. This is a relatively unexplored issue, but one that has nevertheless received intermittent heated debate on Capitol Hill. 

*It’s true that IOER is essentially an uncollateralized loan from banks to the Fed, and that GC Repo is a collateralized loan where a security is exchanged. Yet, if an apples-to-apples comparison is desired, one may compare IOER to the similarly uncollateralized federal funds rate, which also trades well below IOER. We have chosen the GC Repo rate as the standard, since the Fed itself uses it as a preferred benchmark, along with short-term commercial paper rates.