The tools of the Federal Reserve fall into two main categories administered interest rates and open market operations. Administered interest rates include Interest on Reserve Balances, the Reverse Repurchase Agreement Offering rate, and the Discount rate. As of right now, we will dive deeper into the Interest on Reserve Balances (IORB) rate, some of its history and also some insights that can be derived from its behavior.
Interest on reserve balances
The concept of a bank holding some form of money or currency in reserve is not a foreign concept for most people. Prior to March of 2020, there was a reserve requirement set by the Fed that commercial banks and depository institutions were required to adhere to. Essentially, this reserve requirement is the minimum level of reserves than an institution must hold against their liabilities. To illustrate an example, if there is a twenty percent reserve requirement and the institution has $100 million in liabilities, then they must hold $20 million in reserves. The current reserve requirement for depository institutions is zero[1]. Be sure to check the dates for publications related to this and similar facts because they are not updated all the time. In this case, check out the website of the Federal Reserve itself[2] and not one of the reserve banks[3]. The main website for the Fed is updated regularly and the website for the reserve bank is not.
In response to the Great recession, the Fed started paying interest on the reserve balances held by depository institutions, probably as an incentive to maintain adequate reserves to lower the risk of a default. This at least added another mode for depository institutions to increase the size of their balance sheet, at least for the eligible institutions that decided to maintain larger amount of reserves than they were required. Additionally, in March of 2020, the reserve requirement dropped to zero, therefore, all reserves were in excess of the requirement. Since any amount of bank reserves was in excess, the Fed dropped all references to interest relating to either required reserves or reserves held in excess, leading to the two rates merging into a single interest rate Interest On Reserve Balances (IORB). This transition occurred in July 2021 and may signify that the Fed does not plan to re-instate the reserve requirement since they eliminated all reference to it.
As a consequence of the nature of IORB, it can essentially be used as a floor for the Fed funds. Fed funds is a target range of interest rates that depository institutions at the Fed can expect. In the case of IORB, it sets a minimum return of capital for a depository institution since they are receiving interest on their reserves just by parking them at the fed. The rational is why would a bank lend to some other counterparty at a lower rate when they can receive IORB risk-free. This makes logical sense unless the banks can make a higher risk-adjusted return somewhere else. As the risk-free option, IORB pays a mere 0.40%[4], however, with the total amount of reserves held by depository institutions near $4 trillion[5], is not as miniscule in magnitude as its percentage would imply by itself. Both these stats are as of the end of March 2022. It is important to state this as Fed is in the advent of a rate hiking cycle and these rates will most likely change in the near future.
Regardless of the risk appetite for the depository institutions at the time, IORB affects the fed funds (as discussed above) and other short-term interest rates. As a result, IORB influences financial markets through this medium. Possibly the most direct influence being upon overnight money markets as it affects the rate that institutions will accept whether they are borrowing or lending.
Above are the FRED charts for both Interest on Required Reserves (IORR) and Interest on excessive reserves (IOER) starting from October 9th, 2008 and going until they were discontinued. These are daily charts, meaning that each individual point is one day, however, since the total duration of the graph is around twelve years, only the start of each year is shown on the horizontal axis. One thing to note with these FRED charts is that the gray shaded regions show the periods in which the economy was in a recession, so we see that these administered interest rates both dropped during recessions. Another noteworthy point to make is how it moves in a stepwise manner; this is a good sign that it is an administered rate. Unlike rates determined by the market, which can change on a minute-by-minute basis, administered rates are set, stay constant for some time until they are changed. So, this manifests as a function moving in a step like fashion.
To comment the data itself and just some helpful reminders for future reference, below is a chart of the difference between IORR and IOER. Whenever I see to two similar pieces of data, in this case IORR and IOER, I like to take the difference between the two because sometimes it can help give some further insight that may not be obvious by just looking at the chart. In this case, IOER and IORR looked exactly the same, but since it was a daily chart with almost five thousand data points, I wanted to take the difference to confirm they were set at the same value. This difference can be seen below, and as you can see they were equivalent for the most part after that initial bout from October 9th, 2008, to November 5th, 2008. The gap at the beginning of the horizontal axis is for ease of reading as IOER and IORR data were not collected until late 2008 and the ticks are for January 1st of each year.
Since IOER and IORR were equivalent in magnitude after November 5th, 2008, depository institutions saw no change in return on their reserves regardless if they were in excess of the reserve requirement or not. I am doubtful if the first month where IORR was higher that IOER made much of a difference in terms of the incentives for banks to hold excess reserves. Given the time (October to early November of 2008), I am assuming that IORR was larger so that institutions would have their reserve balances increase faster in order to fulfill the reserve requirement. This reasoning is backed by the fact that IOER was elevated as well, so that could imply the intention was just to increase the reserves held by institutions regardless if in excess of the reserve requirement or not. Also, on November 5th, 2008, the two rates began moving in tandem till their discontinuation. Which could lead one to believe this was meant to just steadily increase the reserves in the system over time now that the initial liquidity crisis was more or less resolved.
One thing to keep in mind with the FRED charts is to pay very close attention to the dates. There is a sliding bar below them when you are on the website as well as a place where you can manually type in the dates you want. Make sure when you download the csv or whatever file format you want to use that the dates are correct and consistent when comparing two quantities. Just makes it easier from a data analysis perspective and also when you need to double check yourself.
As can be seen in the chart above, the Interest Rate of Reserve Balances (IORB) started in July of 2021. Considering IOER and IORR have been equivalent since November of 2008, it is not surprising that the Fed decided to just combine the two rates. Nothing changed mathematically, just symbolically. Since there is no longer any mention of the reserve requirement, one might think that this appears to mean that the Fed has no intention of reinstating the reserve requirement. This could be explained by the Fed changing their operating framework from one with limited bank reserves in the system to one in which there are an ample amount of reserves. As defined by the Fed, an ample amount of bank reserves means that the magnitude of reserves is so large that a significant fluctuation would most likely not affect short-term interest rates. More about this operating framework is discussed in the post below.
Final Remarks
Interest rates are the price of money; therefore, they are an excellent measure of perceived risk. A lender will charge a counterparty a higher interest rate if they perceive said counterparty to have a higher risk of default on the loan. This being said, interest rates are largely a market-based phenomenon. I say largely because there is some argument as to how much an affect the Fed’s administered interest rates have on those determined by the market. Regardless of the opinions on how effective these administered rates are at influencing market-based rates, they are a major tool of that the Fed uses to enforce monetary policy. Consequently, further study in the rates themselves, how they are measured, and how they are perceived by the market is justified and necessary for the development of a full understanding of their role in the context of the monetary system and a macroeconomic outlook.
To your wealth and future,
James Forsythe
For a YouTube video going more in depth
[1] https://www.federalreserve.gov/monetarypolicy/reservereq.htm
[2] Ibid.
[3]https://www.newyorkfed.org/research/epr/02v08n1/0205benn/0205benn.html#:~:text=The%20Federal%20Reserve%20requires%20banks,bank’s%20demand%20and%20checking%20deposits.
[4] Interest of Reserve Balances chart, Source: Board of Governors of the Federal Reserve System (US) https://fred.stlouisfed.org/series/IORB
[5] Reserves of Depository Institutions: Total, Source: Board of Governors of the Federal Reserve System (US), https://fred.stlouisfed.org/series/TOTRESNS . For more commentary on this in a different context, https://jamesdforsythe.com/the-federal-reserves-monetary-policy-regime-limited-and-ample-reserves/
