What might happen if the Fed stopped paying interest on excess reserves?

Question

I am curious to hear what economists think might happen if the Fed stopped paying interest on reserves held in excess of the penalty free upper bound. I am also curious to know how economists think this practice might be fazed out gradually in such a way that the Fed could mitigate the negative effects that might accompany a sudden and complete cessation of the practice.

For example - If banks stop earning risk-free profit on these reserves (current at .25 percent, I think) would they feel compelled to channel these excess funds into profitable loans? Perhaps this is a way the Fed could keep interest rates low after ending QE practices? Would ending the interest payments overnight cause banks to start lending such that we would experience significant inflation?

Any feedback, papers, etc. much appreciated!

Answer 1

If the Fed paid paid 0% on excess reserves, banks holding excess reserves would immediately try to buy Treasury bills that paid more than the 0% paid by excess reserves. This would drive Treasury bill (and other short-term risk-free rates) to 0%.

The Fed pays interest on excess reserves to allow short-term market rates to be near their target (which is now above 0%).

Answer 2

Historically banks kept close to the minimum in their reserve accounts. Once the Fed started paying interest, they rapidly put a truly large amount of money in those accounts. If the fed were to stop paying interest, I think we could expect them to go back to keeping the minimum in those accounts.

So what would they do with the money? Buy safe securities? Risky securities? Make more loans? I'd say all of the above. Most likely the bulk of the money would go into subtitutes: very safe securities like T bill and money market securities. Loans would go up by the least amount because the availability of high quality loan opportunities is already the limiting factor.

The influx of cash into the markets (and the new loans) would drive up prices of all investable securities (investors who used to buy T bills will look to alternatives, etc.). It would also cause an expansion of the money supply that would likely lead to inflation.

I actually worry about this quite a bit. It's unprecedented, though, so we don't know what would happen. I think we could anticipate the Fed or government trying to do something to offset the inflation, at least.