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 late in 2008. Since then, the Federal Reserve has paid interest on balances that banks hold to meet reserve requirements and on amounts in excess of required reserves. The Board of Governors sets the interest rate the Federal Reserve pays on reserve balances to help implement the FOMC's monetary policy decisions.
During the monetary policy normalization process, the Federal Reserve intends to raise the interest rate it pays on reserve balances in line with increases in the main monetary policy rate--the target that the FOMC sets for the federal funds rate. Doing so will help control the federal funds rate and keep it in the target range set by the FOMC. When the Federal Reserve raises the IOER rate, banks will take this new, higher rate into account when making decisions about lending funds and would be unlikely to loan funds for an interest rate that is below the IOER rate.
More broadly, as the Federal Reserve increases rates, banks will also have to pay higher rates on their sources of funding--that includes paying more to depositors. And that process will help to boost incomes for savers, many of whom have experienced low returns for quite a few years.
The IOER rate is not the only policy tool at the Federal Reserve's disposal. To learn more about the normalization process and the other monetary policy tools, visit http://www.federalreserve.gov/monetarypolicy/policy-normalization.htm.