Commercial banks must adhere to regulations, including so-called reserve requirements. That is, banks must hold a certain fraction of their deposits as cash in a Federal Reserve account; these are known as “required reserves.” Banks can choose to hold even more cash in those accounts than what the Federal Reserve requires; these are known as “excess reserves.”
The graph above shows that required reserves are quite stable and grow as a constant fraction of total deposits in the banking system. But excess reserves increased considerably in 2008, as the Fed expanded the money supply to finance unconventional monetary policy measures such as quantitative easing. As of May 2018, excess reserves are nearly $1.9 trillion, ten times more than required reserves.
In normal times, excess reserves aren’t profitable, as they don’t earn a return. Instead of holding cash as excess reserves, banks could lend those funds and earn interest. However, after the 2008 recession, the Federal Reserve started paying interest on excess reserves (IOER). By altering the incentives for commercial banks to extend loans or hold excess reserves, the Fed is able to use the IOER as an additional monetary policy tool.
The second graph plots the IOER along with the (effective) federal funds rate, the Fed’s main tool for conventional monetary policy. The federal funds rate can be thought of as the interest rate at which financial institutions make short-term loans to each other. Here, we see that the federal funds rate tracks the IOER very closely. When banks have excess liquidity or reserves, they can choose whether to lend those reserves to other banks (at the federal funds rate) or deposit them at the Fed (and earn the IOER). Banks aren’t willing to lend to each other if the federal funds rate is substantially lower than the IOER, and so the two rates move closely together.
How these graphs were created: For the first graph, search for and select “required reserves of depository institutions” and click “Add to Graph.” From the “Edit Graph” panel, choose “Add Line,” search for and select the monthly “excess reserves of depository institutions” series, and click “Add data series.” The first series is in billions of dollars; to change it to match the second series (in millions of dollars), select “Edit Lines”/”Edit Line 1” and add the formula a*1000. For the second graph, search for and select the monthly “effective federal funds rate” series. From the “Edit Graph” panel, choose “Add Line” and search for and select “interest rate on excess reserves.” Use the date range tool to set the start date in August 2008.
Suggested by Asha Bharadwaj and Miguel Faria-e-Castro.