Whenever a government agency gains a new power, there’s a risk that, whatever the power’s original intent, it will end up being put to other uses, perhaps good, but often bad.
Such is the case for the Fed’s power to pay banks interest on their Federal Reserve deposits. That power was originally awarded to the Fed in 2006 to allow it, starting in October 2011, to reduce banks’ cost of meeting statutory reserve requirements. During the financial crisis the implementation date was moved forward to October 2008, the Fed’s hope at the time having been that a positive interest rate on excess reserves (IOER) would establish a new, above zero “floor” for the effective federal funds rate. However, as I explained in a recent post, because subsequent Fed reserve creation left the banking system flush with reserves, banks had no need to borrow federal funds unless they could profit from the difference between the borrowing rate and the IOER. Consequently, the interest rate on reserves, instead of serving as an effective funds rate floor, ended up becoming a ceiling.