Should the Federal Reserve Pay Interest on Bank Reserves?

July 17, 2025 | President Donald Trump is mounting the most serious challenge to the independence of the central bank since the 1950s, but the direction of government policy is largely dictated by the fiscal deficit of the U.S. Treasury. We commented earlier this month on the transfiguration of Treasury Secretary Scott Bessent from long-bond issuing bull into a meek advocate for funding the public debt short – via discount Treasury bills of varying maturities inside of 18 months. Naturally issuing more 10s and 30s would push LT interest rates higher and also inflate the cost of the public debt.

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Republicans in Congress are desperately looking for budget savings. So this raises the question: Should Congress have given the Federal Reserve the power to pay interest on reserves (IOR), the cash that banks deposit with the central bank? The short answer is yes -- unless you want the U.S. Treasury to default next time the credit markets go sideways.

Like March 2020, when President Donald Trump declared an emergency allowing millions of Americans to stop paying mortgages and rent. For about 60 days thereafter, nobody in the world of residential housing finance knew how they were going to pay interest on $12 trillion in mortgage debt and avoid default. The Trump White House did not ask. Until the Fed came to the rescue with massive purchases of securities, every commercial bank, mortgage lender, municipality and the United States itself would have defaulted a month later.

Fact is, if we did not have $40 trillion in public debt, nobody would be worried about paying interest on reserves at the Fed. The authority for the Fed to pay IOR on deposits by banks was initially granted by the Financial Services Regulatory Relief Act of 2006, with an effective date of 2011. The 2008 financial crisis prompted Congress to accelerate the implementation so as to enable the commencement of massive purchases of securities (aka "quantitative easing" or QE). Sec 201 of the Act states:

‘‘(A) IN GENERAL.—Balances maintained at a Federal Reserve bank by or on behalf of a depository institution may receive earnings to be paid by the Federal Reserve bank at least once each calendar quarter, at a rate or rates not to exceed the general level of short-term interest rates.”

The proposal was highlighted in an April 2004 letter from Fed Chairman Alan Greenspan to Senator Richard Shelby (R-AL), who was then the Chairman of the Senate Banking Committee, and Senator Mike Crapo (D-ID), in response to their request for the Board's top legislative priorities for regulatory relief.

Two decades ago, Governor Donald Kohn, who was formerly Director of the Division of Monetary Affairs of the Board staff, testified before Congress on the operational and policy reasons for giving the Fed the authority to pay interest on reserve balances. Three factors were cited: Simplifying the market for reserves and eliminating incentives for arbitrage by banks, eliminating entirely the need for banks to keep required reserves at the Fed, and giving the Fed the ability to manage the rate for federal funds, the short-term market that has been effectively nationalized by the central bank over three decades. 

This last factor, forseen by Chairman Greenspan, Governor Kohn and the Board staff two decades ago, was the chief reason for the proposal, but the true reason was still discussed in catious terms: the growing federal debt. In testimony before Congress in 2004, Kohn summarized precisely the situation facing the Fed today and the chief reason why the central bank must be able to pay interest on reserves to manage short-term dollar interest rates. Kohn:

“While overnight interest rates have exhibited little volatility in recent years, even when the sum of required and contractual balances was considerably smaller than at present, volatility nevertheless could potentially become a problem at some future time if such balances fell to very low levels. Such a development might be possible if interest rates were to rise to high levels, which would reduce the demand for required and contractual balances and provide extra incentives for reserve avoidance. Paying interest on such balances is one way to ensure that they do not drop too low.”

Even in 2004, when the party was starting to end in residential mortgages and the federal debt was just over $7 trillion, the Fed saw that the growth in the government debt markets would soon require new tools for monetary policy. Specifically, the Fed needed a way to finance the purchase of government debt without directly boosting inflation. Borrowing cash from banks was seen to be less damaging to the economy, but obviously the inflation from QE flowed into housing nevertheless.

More than a decade before the Fed actually began to use massive open market purchases of Treasury debt as a policy tool, the central bank essentially anticipated the future need. In 2016 testimony, Dr. George Selgin of Cato Institute described how the rationale for paying IOR mutated from a general policy initiative to something far more specific a decade later:

“The rationale behind the early deployment of the Fed’s authority to pay interest on reserves was entirely different from that behind the original, 2006 measure. Interest on reserves (henceforth IOR) was to be relied upon, not as a means for improving banks’ efficiency, but as a new Federal Reserve instrument of monetary control. Specifically, it was resorted to as a contractionary monetary measure, meant to prevent monetary expansion that would otherwise have taken place as a consequence of the Fed’s post-Lehman emergency lending operations.”

As the size of the government debt has grown, the Fed anticipated that it would need to fund larger and larger open market operations. These operations flow through the financial statements of the largest banks in a dreadful arithmetic of inflation and deflation. When the Fed buys securities for its portfolio, it creates deposits in the banking system in the form of reserves and bank assets rise, but with little profitability. When it shrinks the portfolio, as it is doing now (“Waller Wants Lower Reserves & Tighter Policy“), it destroys bank deposits as the Treasury deficits consume the available cash.

Bill Nelson, Chief Economist of the Bank Policy Institute, said in an optimistic December 2019 talk entitled, "The Fed’s Balance Sheet Can and Should Get Much Smaller":

"The quantity of reserves that the Fed has judged to be necessary for reserves to be abundant has grown remarkably over time. In April 2008, when Federal Reservet considered the possibility of operating policy with an abundant-reserves framework, It estimated that the level of reserves that would be needed '…might be on the order of $35 billion but could be larger on some days.' The assumption rose to $100 billion in 2016, $500 billion in 2017, and $600 billion in 2018. It is not possible to know precisely what level the FOMC judged necessary at the beginning of this year when it made its decision to adopt a large-balance-sheet framework because the Fed decided to break with its own tradition and not disclose its forecast. However, available information suggests that at that time the FOMC judged about $1 trillion in reserves was abundant. I’d guess that their current estimate is about $1½ trillion."

Notice that the minimum amount of reserves given by Governor Waller last week has exploded since 2019. The Fed needs to pay interest on reserves to balance demand for deposits at the Fed with the market rate on T-bills and money market funds. If the Fed could not pay interest on reserves, then it could no longer finance large open market purchases of Treasury securities.  If the Fed expanded its balance sheet by purchasing Treasury bills and paid for these earning assets with zero yield reserves, banks would sell reserves and buy bills and other earning securities, driving market interest rates to zero or below.

If there were no federal deficit or massive debt, then reserves would be scarce. As a century ago, banks would have to hold municipal bonds, mortgage and agency securities, and corporate bonds for cash liquidity. Reflecting this 19th Century worldview, some conservatives in Congress think that ending QE is a good idea. No, eliminating the federal deficit is the solution. In the next credit market crisis, without QE, the Treasury market will just close. Quantitative easing and paying interest on reserves are two necessary evils when the US government has $40 trillion in debt and counting.  

The Federal Reserve is now the banker of last resort to the US Treasury, inflating and deflating the economy with its balance sheet. Think of bank reserves held at the Fed as another form of T-bills that the government issues when it must repurchase its own debt, via its alter ego, the Federal Reserve Board. Paying interest on reserves and on reverse repurchase agreements (RRPs) is essentially the same activity. The Fed must pay interest on reserves for the same reason that the Treasury pays interest on its debt, because the ebb and flow of cash in and out of the financial markets must always balance.  The chart below shows total owned securities, mortgage backed securities and RRPs by the Fed.

Contrary to what some economists and members of Congress believe, there is no bonanza here for commercial banks. QE has hurt bank profitability and paying interest on reserves is a modest compensation. Interest-bearing deposits with the Federal Reserve, non-U.S. central banks and other banks earned 4.15% for Bank of America (BAC) in Q2 2025, but BAC’s cost of interest bearing liabilities was 3.43%. The risk free return on bank reserves for Bank America was around three-quarters of a point, as shown in the table below.

Naturally, the Fed does create bank reserves out of thin air to pay for quantitative easing, a policy course that has caused the central bank to rack up hundreds of billions in losses but kept the market for Treasury debt open for a while longer.  Think of the losses incurred by the Fed from its sloppy handling of quantitative easing as part of the cost of the Treasury's massive debt. The worst asset allocation choice made by Chair Janet Yellen and Chairman Jerome Powell was purchasing trillions of dollars in mortgage backed securities, which boosted home prices and is the main cause of the operating losses at the Fed.

Would ending Fed interest payments on bank reserves save the government money? Senator Ted Cruz (R-TX) says it would, but he is mistaken. Before Cruz and others in Congress go down this road they should understand the real world issues that drove Chairman Shelby to sponsor the legislation 20 years ago that allowed the Fed to pay IOR. Paying interest on reserves has nothing to do with whether banks lend in the private sector and everything to do with enabling the Fed to manage the Treasury market. If you don’t want the Treasury market to remain open, then take away the Fed’s power to pay interest on reserves.  

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