Reforming the Federal Reserve, Part 5: Ending the Interest on Reserves Program

The Fed has mostly waved away concerns over IOR losses, but the truth is that the IOR program is economically costly, endangers the Fed’s price stability mandate, and amounts to government support for the financial sector. For instance, the Fed’s audited financial statements for 2023 and 2024 show that the Fed suffered billions of dollars of operating losses due to the large amounts of interest it pays on bank reserves. Losses on interest payments make it costly for the Fed to fight inflation, threatening its price stability mandate. These data should worry even the most ardent of Fed defenders. It is time to put an end to the interest on reserves program and require the Fed to conduct rules-based monetary policy that disrupts individuals’ and firms’ economic decisions as little as possible.

The Fed drastically changed its operating framework following the financial crisis of 2008. At the time, most of the attention fell on the Fed’s quantitative easing program. The Fed’s asset purchases during the crisis also prompted it to begin paying commercial banks IOR deposited at the Fed in excess of the legally required amount. To help with economic stabilization during the COVID-19 pandemic, the Fed announced it would eliminate reserve requirements altogether, essentially making all reserve deposits excess reserves and eligible for interest payments.

To be fair, there are economically justifiable reasons to pay IOR to banks. In a fiat money regime, these reserves can be created at a zero marginal cost. Consequently, for economic efficiency, the opportunity cost to banks for holding these reserves should be zero as well. This outcome could be achieved by paying banks interest commensurate with the returns they could make on low-risk short-term assets. Despite its original intent, the Fed’s IOR program has morphed beyond simply covering banks’ opportunity costs for holding reserves. It now threatens the Fed’s core functions and has made the Fed overly entrenched in financial markets.²

After it created enormous amounts of reserves during the 2008 financial crisis, the Fed began relying heavily on the IOR framework because it gave the Fed better control over its ultimate policy rate—the federal funds rate (FFR). The FFR is the overnight rate at which banks lend reserves to each other. Since the FFR is the cost for banks to acquire reserves, the FFR in turn can affect the rate at which banks are willing to lend money to their customers. Thus, by influencing the FFR, the Fed can ease or tighten financial conditions, allowing it to influence the real economy, at least in theory.

The Fed’s flooding of the banking system with reserves in the aftermath of the 2008 crisis necessitated reliance on the IOR program because the Fed lacked a way to dissuade banks from using those reserves to create new loans and deposits. In this type of “abundant reserve” framework, changing the quantity of these reserves no longer affects the FFR, so normal open market operations—the buying and selling of Treasury securities—became an ineffective tool for implementing monetary policy. However, the IOR should still be effective at changing the interbank lending rate because banks generally will not lend to other banks at rates lower than the risk-free rate at which they can collect interest from the Fed. Consequently, changing the IOR rate to affect the cost of holding reserves is now the Fed’s main instrument for changing the FFR and thereby conducting monetary policy.³

When the Fed made the decision to suspend reserve requirements in March 2020, interest rates were at an all-time low—the IOR opened at just 10 basis points following the Fed’s announcement. The Fed’s decision to pay interest on all reserves, rather than only on excess reserves, made no difference in practice because interest payments were small. However, as careful observers had warned for a decade, the Fed’s IOR policy spells disaster in a world with high interest rates—the world we live in now.⁴

Indications of the harmful effects of IOR policies have been present since the COVID-19 pandemic. To accommodate its pandemic-related large-scale asset purchases, the Fed drastically increased banks’ reserves and paid interest on all these newly minted reserves. Consequently, banks had little incentive to borrow from each other or lend funds to the public, resulting in significantly lowered activity in the federal funds market.⁵ In turn, this inactivity led to a dampening of the effects of the FFR on other borrowing costs.⁶ At the same time, inflation went far beyond the Fed’s 2 percent target, ultimately requiring the Fed to severely tighten its monetary policy stance. By late 2023, the Fed had increased the FFR by raising the IOR rate to 5.40 percent. The consequence of this post-pandemic policymaking was a dramatic increase in both the principal and interest rate of the Fed’s liabilities.

As Figure 1 shows, the Fed’s interest payments have increased exponentially as a result. (All dollar values have been adjusted for inflation by converting them to their equivalent in 2024 dollars.) Moreover, the rate of increase in interest expenses mirrors the rate of increase in the IOR. The latter was not true in the late 2010s when the Fed raised the policy rate but kept interest payments in check because it paid interest only on excess reserves instead of on all reserves.

It was no surprise, then, that the Fed reported operating losses of $111 billion in 2023, driven largely by interest expenditures. The Fed followed suit in 2024 with a $77.6 billion loss, again mostly from interest payments. As Figure 2 shows, these were the first recorded losses since 2008 and the only losses on record since the data became available. Such losses are especially likely if increased IOR rates are not offset by similar increases to the rates of return on the Fed’s assets. As recent Cato CMFA research has shown, as the Fed’s losses have mounted, several key borrowing rates in the market have become less correlated with the Fed’s policy rate.⁷

Fed officials are largely unconcerned about losses from interest payments. The losses are simply marked down as an IOU called a “deferred asset,” essentially allowing the Fed to monetize its own debt with a promise to use future profits to offset these write-offs. According to a press release: “A deferred asset has no implications for the Federal Reserve’s conduct of monetary policy or its ability to meet its financial obligations.”⁸ This nonchalance is dangerous and unwarranted. It is technically true that the Fed can continue to exhibit losses, as it does not require operational profitability like a private financial firm does. (Indeed, if the Fed were a private bank, any one year of such losses may have been enough to shutter its business.) But, while the Fed is not a private bank and it can sustain these losses for a longer period, it is not true that there are no causes for concern beyond profitability. There are three major reasons for concern over the IOR framework and resulting losses.

First, the economic costs of these losses are high. Assuming that marking off future profits to account for current losses has no economic effects is economically unsound. Balancing books via accounting rules ignores opportunity costs. That is, accounting rules do not quantify the gains that could have been achieved from using funds for alternative purposes, such as paying down federal debt. In fact, for decades profits from the Fed’s operations have been remitted to the Treasury and gone toward paying off the federal government’s massive fiscal deficit. Now, as a result of higher interest rates, future Fed profits will be funneled toward canceling deferred assets instead of helping with the government’s borrowing bill. Instead, the Treasury will have to issue even more debt in this amount, which will lead to an even greater fiscal imbalance. In other words, these higher interest payments will place a higher burden on future taxpayers even though the Fed’s accounting costs appear to be zero.

Second, the IOR framework creates a conflict of interest with the Fed’s mandate to stabilize prices. As discussed, the Fed’s primary mechanism for achieving stable prices is to influence the federal funds rate by altering the IOR. Specifically, to combat inflation, the Fed tightens its monetary policy stance by raising the IOR.

However, as shown in Figures 1 and 2, increases in the IOR result in large interest expenses and consequently losses for the Fed. Despite what they may claim publicly, Fed officials cannot continue to exhibit losses on their financial statements indefinitely. Realistically, at some point, large financial losses would undermine the Fed’s ability to support the banking sector and the US government’s ability to issue new debt, just as it would in politically unstable countries. Moreover, losses create a potential complication for monetary policy because the Fed must increase the IOR to combat inflation even though every increase in the IOR rate increases the Fed’s potential losses.⁹ This inherent conflict only makes the Fed’s fight against inflation more difficult.

Third, the IOR system facilitates government support for the private financial sector. At its core, the IOR policy is a government subsidy to large financial institutions. Banks now have their own risk-free savings accounts, giving them returns that are hundreds of basis points higher than what regular consumers receive on their own deposits at the very same institutions. If that isn’t bad enough, the billions that banks receive in interest payments have reduced their incentive to lend in the private market, reducing the cash available to regular Americans to borrow while flooding the banking system with trillions in reserves. In an environment where financial institutions serve as the boogeyman for politicians on both sides of the political aisle, it seems only a matter of time before at least one political party threatens the Fed’s ability to conduct policy using IOR.

The Fed has lost billions of dollars by paying interest to large banks on their reserves. This policy is economically costly, threatens the Fed’s mandate to stabilize prices, and is unfair to everyday Americans. It is imperative that the IOR policy is repealed and the Fed’s operating framework is returned to its pre-2008 system. Along with other restrictions on the Fed’s ability to purchase securities, these policy changes would make it harder for Congress to use the Fed for backdoor fiscal expenditures and for the Fed to serve as an instrument of credit allocation.