The central bank is using this method to discourage lending at rates it considers too low. As it raises rates to counter inflation, though, it also pays the bankers more and more.
So far this year, the Fed has paid out more than $28 billion, a number that might easily double or even triple by the end of the year, depending on whether and how much the Fed will continue to raise interest rates.
How it Works
When people and companies put their money in a bank, it’s usually in an electronic form. The bank keeps the money in a “reserve” account at the Fed. Starting in 2008, the Fed started to pay interest on these “reserves.”
With the massive injection of new dollars in the form of various relief measures during the COVID-19 pandemic, reserve balances skyrocketed to a peak of more than $4.2 trillion in December 2021 from about $1.7 trillion in February 2020.
Since then, reserves have slipped to less than $3.3 trillion, but that’s largely due to another Fed measure—reverse repurchase agreements, or reverse repos.
A reverse repo means a bank buys Treasurys from the Fed, only to sell them back a day later at a slightly higher price. The reverse repo rate is a bit lower than the interest on reserves rate. As such, banks could actually profit more by not engaging in reverse repos—yet they do.
Reverse repo volumes increased to about $1.7 trillion a day in February from virtually zero in February 2021, and further to more than $2.2 trillion a day in the past three months or so.
There are three reasons for such a robust interest in reverse repos.
First, aside from banks, money market funds are also allowed to participate. Such funds invest in short-term debt securities and are regulated by the Securities Exchange Commission to minimize risk for investors.
Second, banks don’t like to hold reserves too large as it makes their balance sheets look bloated. Parking cash in reverse repos makes the reserve balance look lower.
Third, reverse repos provide instant cash flow. While interest on reserves is paid out by the Fed every two weeks, reverse repos pay every day.
Together, interest on reserves and reverse repos act as a “floor … beneath which banks and non-bank financial institutions should be unwilling to invest funds in private markets,” the Federal Reserve Bank of New York says on its website.
Simply said, the Fed is paying banks and money market funds to invest less. It’s also a convenient way for banks to make money because it saves them the trouble of looking for worthwhile investment opportunities. The Fed can simply create the money needed to pay the interest.