The Federal Reserve has a new tool in its arsenal to fight inflation. The Fed can now pay interest on depository institutions’ required and excess reserve balances.

This new authority is extremely useful for the Fed because fighting inflation is one of the primary goals of the Fed.

[VIDEO] Why the Fed Pays Interest on Excess Reserves

How the Fed Got the Authority to Pay Interest on Reserves

The Financial Services Regulatory Relief Act of 2006 originally authorized the Federal Reserve to begin paying interest on balances held by or on behalf of depository institutions beginning October 1, 2011. The recently enacted Emergency Economic Stabilization Act of 2008 accelerated the effective date to October 1, 2008.

If the timeline had not been accelerated from October 2011 to October 2008, the Fed would most like have had to rely more on its open market operations to combat inflation, rather than on raising reserve requirements.

How Much Interest Will the Fed Pay

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The interest rate paid on required reserve balances will be the average targeted federal funds rate established by the Federal Open Market Committee over each reserve maintenance period less 10 basis points. Paying interest on required reserve balances should essentially eliminate the opportunity cost of holding required reserves, promoting efficiency in the banking sector. The rate paid on excess balances will be set initially as the lowest targeted federal funds rate for each reserve maintenance period less 75 basis points.

What Impact Will Paying Interest on Reserves Have?

Paying interest on required reserve balances should essentially eliminate the opportunity cost of holding required reserves, promoting efficiency in the banking sector. This will also enable the Fed to raise reserve requirements if inflation becomes a problem without doing too much damage to the bottom line of already-fragile banks.

Paying interest on excess balances should help to establish a lower bound on the federal funds rate.

The payment of interest on excess reserves will also permit the Federal Reserve to expand its balance sheet as necessary to provide the liquidity necessary to support financial stability while implementing the monetary policy that is appropriate in light of the System’s macroeconomic objectives of maximum employment and price stability.