The Federal Reserve's Interest Rate Control System (Part II) — Introduction of the Interest on Excess Reserves

In the previous article, we reviewed the Federal Reserve's interest rate corridor system before the 2008 financial crisis ("A Detailed Explanation of the Federal Reserve's Interest Rate Control System (Part I)"). At that time, due to the limited Reserves that banks held at the Federal Reserve, the Fed used the discount window rate as the upper limit and open market operations to control the lower limit.

However, following the 2008 financial crisis, the Federal Reserve implemented large-scale quantitative easing, significantly increasing market liquidity and rendering the interest rate corridor system ineffective. To address this situation, the Federal Reserve introduced the Interest on ExCESs Reserves (IOER) in 2008 as the new lower limit for interest rates. This article will analyze this policy shift in detail and its impact on the interest rate control system.

Introduction of the Interest on Excess Reserves (IOER)

The IOER refers to the interest paid by the Federal Reserve on the portion of bank reserves held in excess of the required reserves. Before 2008, the Federal Reserve did not pay interest on bank deposits, resulting in an ineffective lower limit for the U.S. interest rate corridor, relying instead on open market operations to control market interest rates. However, the unprecedented liquidity glut brought about by the financial crisis severely undermined the effectiveness of open market operations, causing market interest rates to plummet.

To counter this, the Federal Reserve introduced the IOER in October 2008, aiming to limit the decline in market interest rates by paying interest to banks. When the interest rates banks could obtain in the market fell below the IOER, they were more inclined to deposit their excess funds at the Federal Reserve, thereby maintaining market interest rates above the IOER level.

The Shift of IOER: From Lower Limit Tool to Upper Limit Tool

Although this measure initially succeeded in curbing the downward trend of interest rates, it became evident that non-bank financial institutions, which held large amounts of cash and could not directly utilize the IOER, continued to drive market interest rates lower, eventually breaching the IOER floor.

Interestingly, the Federal Reserve discovered that in an environment of extreme liquidity, the IOER began to function as an upper limit for interest rates. When the market was awash with funds, and banks' reserve balances at the Federal Reserve surged, market interest rates rose. Banks would withdraw reserves from the Federal Reserve and lend them at higher market rates, causing market interest rates to fall back below the IOER.

This phenomenon demonstrated that in conditions of abundant liquidity, the IOER's role as a lower limit tool weakened, but it inadvertently assumed the role of an upper limit for interest rates. In December 2008, the Federal Reserve adjusted the federal funds rate target range to 0-0.25% and set the IOER at the upper limit of this range, further confirming the IOER's new function as an upper limit within the interest rate corridor.

The Logic of Interest Rate Control Amidst Liquidity Glut

As banks' reserve balances at the Federal Reserve skyrocketed from around $10 billion before 2008 to $800 billion by early 2009, and even reached $3 trillion in subsequent years, the logic of interest rate control fundamentally changed.

Under normal reserve levels, the IOER could effectively serve as a lower limit for interest rates. However, in a scenario of excessive market liquidity, the IOER's impact on curbing interest rate declines was limited.

When market interest rates exceeded the IOER, banks would withdraw reserves from the Federal Reserve and lend them at higher market rates, increasing market funds and causing interest rates to fall. This mechanism gradually transformed the IOER into an upper limit tool for interest rates, while the traditional discount window rate lost its dominant role in interest rate control.

Market Impact of IOER: An Analogy with the Pork Market

To vividly explain this shift, consider an analogy with the "pork market": suppose a pork factory sets an upper price limit for pork at 20 yuan and controls prices through market supply. When market supply is excessive, pork prices fall, but the factory buys back pork from certain vendors at 10 yuan. However, the market supply remains overwhelming, causing prices to continue falling, eventually breaching the 10-yuan floor.

Subsequently, pork prices rebound, but regardless of market fluctuations, prices never exceed 10 yuan. The reason is that when prices exceed 10 yuan, pork vendors withdraw previously stored pork from the factory and sell it at higher prices, stabilizing prices. This is akin to the IOER's role in financial markets: when market interest rates rise above the IOER, banks withdraw reserves from the Federal Reserve and lend them at higher rates, ultimately pushing interest rates back down to the IOER level.

Conclusion

The introduction of the Interest on Excess Reserves, initially intended as a lower limit tool within the interest rate corridor, gradually assumed the function of an upper limit amidst excessive market liquidity. This shift not only reflects the profound impact of the financial crisis on monetary policy but also marks the Federal Reserve's adaptation and adjustment to interest rate control in the new normal.