Interesting piece in the World Economics Association’s Real World Economic Review on some of the difficulties the Fed faces when it begins tightening monetary policy. They point out the policy contradiction that paying interest on excess reserves is an injection of liquidity as they are trying to tighten.
Money quote:
…the payment of higher interest rates on excess reserves promises to be very expensive. It is also expansionary, which runs counter to the purpose of raising interest rates. The expense is very clear. Given banks hold $2.6 trillion in total reserves, every one hundred basis point increase in interest rates costs the Federal Reserve $26 billion. If the Fed’s policy interest rate returns to 3 percent, that would cost $78 billion. That is an effective tax cut for banks because the Fed would pay banks interest, which would reduce the profits it pays to the Treasury. The banks, which were so responsible for the financial crisis, would therefore emerge winners yet again. Taxpayers, who bailed out the banks, would once again bear the cost.
Paying interest to banks would also run counter to macroeconomic policy purpose since it would be pumping liquidity into the banks when policy is explicitly trying to deactivate liquidity. That smacks of policy contradiction.
Global Macro Monitor 