Fed Paid Banks and Funds $400 Billion Over 2 Years for Sitting on Cash

Federal Reserve Chairman Jerome Powell is introduced at the Jacques Polak Research Conference at the International Monetary Fund in Washington on Nov. 9, 2023. (Mark Schiefelbein/AP Photo)

The banking industry has benefited from the Federal Reserve’s measures to control inflation. Over the past two years, the U.S. central bank paid out more than $400 billion to banks and money market funds in interest payments and other transactions meant to curb lending to fight inflation, based on data published by the Fed as of July 1.

After a rate hike spree in 2022 and 2023, the central bank now pays 5.4 percent annual interest on “reserves”—any money that a bank leaves parked at the Fed overnight. The banks, on the other hand, haven’t necessarily passed on the windfall to customers, as deposit rates remain low compared with the rates that banks receive from the Fed. Customers would often have to use less convenient tools, such as certificates of deposit, to access rates comparable to what the Fed currently pays.

The Fed has been authorized by Congress to pay interest on reserves and has done so since 2008. For many years, the interest was only about 0.1 percent as the Fed was keeping rates near zero. In 2022, however, inflation spiked to a 9 percent annual rate, prompting the Fed to rapidly raise the rates.

Interest on reserves creates a strong incentive for banks to only lend at rates higher than what the Fed offers because leaving deposits in their Fed accounts requires virtually no work and no risk.

The Fed is using this mechanism to tighten credit, depress demand, and thus ease price inflation pressure. Constraining lending also reduces the amount of dollars in circulation because banks de facto create new money as they issue loans. The new money then leaves circulation when the loans are repaid.

Another mechanism is called a “reverse repurchase agreement,” or reverse repo, in which the Fed sells treasuries with an agreement to buy them the next day for a slightly higher price. The price difference is expressed by the Fed as an annual rate and is affected by the Fed’s rate hikes, with its key rate currently standing at 5.3 percent.

Although that’s less than the interest on the reserves, a reverse repo provides better cash flow because it pays every day, and the interest on reserves is paid every two weeks. Also, reverse repos are open not just to banks, but also to money market funds.

Reverse repos have dropped from a peak of more than $2.5 trillion on Dec. 30, 2022, to some $660 billion on June 28.

Interest on reserves and reverse repos has cost the Fed about $3.5 billion a week, based on the weekly averages of reserve balances at the Fed and daily reverse repo volumes.

It’s technically not a problem for the Fed to pay hundreds of billions of dollars in interest because it can create new money electronically. New dollars, however, increase inflationary pressure.

Since its peak in mid-2022, price inflation has dropped significantly, based on data from the Bureau of Labor Statistics. Over the past year, however, it has remained above 3 percent—and the Fed’s target 2 percent rate. An alternative measure of price inflation published by the Bureau of Economic Analysis has posted somewhat lower figures—2.6 percent for May—which is still above the Fed’s target.

Markets are expecting the Fed to start lowering the rates later this year, perhaps in September, although the cuts are expected to be gradual, such as a quarter of a percentage point every six weeks.

Americans may have noticed the high interest rates in mortgages and car loans, but also in interest offered by banks on deposits.

Some smaller banks now offer high-yield savings accounts with interest above 5 percent.

Of the four largest banks—JPMorganChase, Bank of America, Citibank, and Wells Fargo—only one appears to currently offer a similar type of high-yield account.