Interest on Reserves and the Fed's Balance Sheet
The Federal Reserve's balance sheet has expanded dramatically after three rounds of quantitative easing (QE). Consequently, the monetary base (reserves plus currency) has gone from less than $800 billion before the financial crisis to nearly $4 trillion today. Because reserves are a very large part of the Fed's balance sheet, I will start the balance sheet and then consider the issue of the Fed paying interest on those reserves. Changes in the Fed's Balance Sheet The best way to understand what has happened to the Fed's balance sheet in recent years is to look at the actual balance sheet--the consolidated statement of and of all Federal Reserve Banks. Table 1 gives two snap shots of the Fed's balance sheet, one taken in 2016 and the in 2006. Table 1 focuses on the Fed's major and liabilities, lumping everything else into other liabilities and other assets categories. The two points in time--the week ending May 11, 2016, and the corresponding week ending May 10, 2006--give before and after pictures of the major changes in size and composition of the Fed's balance sheet. It is striking how the size of the balance sheet--measured by total assets--has expanded during the last decade: from $842 billion to $4,478 billion. There are two major reasons for the increase. First, currency (Federal Reserve Notes) increased from $758 billion to $1,407 billion, an average annual growth rate of about 6 percent. There is nothing very unusual about this increase in currency; the annual growth rate was in this range in prior decades. The second reason is much more unusual: securities held outright by the Fed jumped from $760 billion to $4,234 billion as the Fed engaged in three bouts of large-scale purchases of Treasury securities and mortgage-backed securities--actions commonly called unconventional monetary policy or QE. (1) To get the funds to purchase these securities, which increased by much more than the increase in currency, the Fed credited banks deposits on itself, and for this reason reserve balances--the deposits that banks hold at the Fed--have exploded from only $14 billion to $2,410 billion as shown in Table 1. This large increase in reserve balances is very important because it is on these reserve balances that the Fed is paying interest today. Figure 1 provides some important details about the increase in bank reserves held at the Fed and illustrates how unusual that growth has been. Reserve balances rose sharply at the times of QE1, QE2, and QE3 as the Fed ramped up its purchases of securities and financed them by creating reserve balances for the banks at the Fed, effectively borrowing the funds from banks. Reserve balances tend to drift down after each of these surges as currency creation continues its upward march and reduces the Fed's need to create reserve balances. The increase in reserve balances began before the onset of quantitative easing when the Fed set up liquidity facilities to provide lender of last resort loans during the panic in September 2008. (2) However, the need for that liquidity support was temporary, and it dissipated soon after the panic, as illustrated in Figure 1 by the dashed line for reserve balances with liquidity support only. That line represents a path for reserves that could have occurred if none of the bouts of QE had taken place. Clearly QE is the cause of the large amount of existing reserves. [FIGURE 1 OMITTED] [FIGURE 2 OMITTED] Interest on Reserves Such a large increase in the supply of reserves no increase in the demand for reserves has clear implications for market interest rates: the increase in supply would be expected to drive down the federal funds rate, which is the rate banks charge each for the overnight use of the reserves. In fact, this is exactly what happened, as shown in Figure 2 for the weeks in fall of 2008. …