Interest on Reserves: A Review of the Federal Reserve’s New Monetary Policy Tool Zamira Simkins University of Wisconsin-Superior Wisconsin Economics Association.

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Interest on Reserves: A Review of the Federal Reserve’s New Monetary Policy Tool Zamira Simkins University of Wisconsin-Superior Wisconsin Economics Association Annual Conference November 9-10, 2012

Traditional Central Bank Key objectives: 1.Low inflation 2.Sustainable economic growth 3.Financial system stability 4.Stable interest rates 5.Stable exchange rates Monetary policy tools: 1.Open Market Operations 2.Discount rate 3.Reserve requirement

Interest on Reserves Friedman (1960) ▫Opportunity cost of holding RR ▫IOR = market interest rate Goodfriend (2002) ▫IOR as a monetary policy tool

Interest Rate Policy Regimes Demand Supply Disc. rate FFR1 Reserves A. Open Market Operations Demand Supply Disc. rate FFR1 Reserves B. Interest on Reserves FFR2 ii Q1Q2Q1 IOR Q2 IOR

Benefits of IOR Regime Enables the Fed to conduct monetary policy even when interest rates are near zero Enables the Fed to pursue additional monetary policy objectives Allows the Fed to inject liquidity (i.e. reserves) in financial markets

Fed and IOR Fed had no legal authority to pay IOR prior to 2008 Financial Services Regulatory Relief Act (2006): IOR effective October 1, 2011 Emergency Economic Stabilization Act (2008): IOR effective October 1, 2008

Key Interest Rates in 2008

Key Interest Rates after 2008

Liquidity Crisis Liquidity crisis is a state in which financing economic activities, either via borrowing or selling of financial instruments, becomes difficult Liquidity crisis indicators: ▫Declining prices of financial assets ▫Downgrading of securities ratings ▫Increasing TED spread

T-Bill - Eurodollar (TED) Spread

IOR and Liquidity

Conclusion US liquidity conditions are still tight Between January 2007 and December 2011, excess reserves grew from $1.5 billion to $1.5 trillion Interest on excess reserves is reducing the opportunity cost of not lending

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