Why is the Federal Reserve paying banks interest?
The payment of interest on banks' reserve balances is a common monetary policy tool at the disposal of major central banks. The Congress authorized the Federal Reserve to pay interest on balances that banks hold at the Fed, effective in late 2008. Since then, the Federal Reserve has paid interest on those balances. The Board of Governors sets the interest rate the Federal Reserve pays on reserve balances (the IORB rate) to help implement the FOMC's monetary policy decisions.
Adjustments to the IORB rate help to move the federal funds rate into the target range set by the FOMC. Banks should be unwilling to lend to any private counterparty at a rate lower than the rate they can earn on balances maintained at the Federal Reserve. As a result, an increase in the IORB rate will put upward pressure on a range of short-term interest rates. The opposite holds for a decrease in the IORB rate. Typically, changes in the FOMC's target range are accompanied by commensurate changes in the IORB rate, thus providing incentives for the federal funds rate to adjust to a level consistent with the FOMC's target.