The central bank now pays 5.4 percent annual interest on ’reserves’—any money a bank leaves parked at the Fed overnight.
The banking industry has benefited from the Federal Reserve’s measures to control inflation. Over the past two years, the U.S. central bank paid out more than $400 billion to banks and money market funds in interest payments and other transactions meant to curb lending to fight inflation, based on data published by the Fed as of July 1.
After a rate hike spree in 2022 and 2023, the central bank now pays 5.4 percent annual interest on “reserves”—any money that a bank leaves parked at the Fed overnight. The banks, on the other hand, haven’t necessarily passed on the windfall to customers, as deposit rates remain low compared with the rates that banks receive from the Fed. Customers would often have to use less convenient tools, such as certificates of deposit, to access rates comparable to what the Fed currently pays.
The Fed has been authorized by Congress to pay interest on reserves and has done so since 2008. For many years, the interest was only about 0.1 percent as the Fed was keeping rates near zero. In 2022, however, inflation spiked to a 9 percent annual rate, prompting the Fed to rapidly raise the rates.
Interest on reserves creates a strong incentive for banks to only lend at rates higher than what the Fed offers because leaving deposits in their Fed accounts requires virtually no work and no risk.
The Fed is using this mechanism to tighten credit, depress demand, and thus ease price inflation pressure. Constraining lending also reduces the amount of dollars in circulation because banks de facto create new money as they issue loans. The new money then leaves circulation when the loans are repaid.
Another mechanism is called a “reverse repurchase agreement,” or reverse repo, in which the Fed sells treasuries with an agreement to buy them the next day for a slightly higher price. The price difference is expressed by the Fed as an annual rate and is affected by the Fed’s rate hikes, with its key rate currently standing at 5.3 percent.
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