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short essays and reports on the economic issues of the day
2008 ■ Number 15

Monetary Policy’s Third Interest Rate
Richard G. Anderson


he federal funds rate and the discount rate are familiar
monetary policy terms. Textbooks typically describe
Federal Reserve monetary policy in terms of setting a
policy target for the federal funds rate, often guided by a Taylor
rule–style equation. Texts also discuss the discount rate, the rate
of interest charged to banks and other depository institutions on
loans they receive at the Fed’s discount window. Today, the Fed
offers three discount programs: primary credit, secondary credit,
and seasonal credit, each with its own interest, or discount, rate.
The implementation of monetary policy in developed
economies, in addition to a policy target rate and one or more
discount rates, features a third, less-discussed interest rate—the
“remuneration rate,” which is the rate of interest the central bank
pays on the deposits that banks hold at the central bank.1 This
interest rate, through its interaction with the policy target rate
and the primary credit, or discount, rate charged on borrowings
from the central bank, is important in the implementation of
monetary policy. The interaction among the three interest rates
results from an unusual aspect of central banking: Central banks
can simultaneously affect (and sometimes closely control) the
supply of and demand for deposits at the central bank. The monetary role of deposits held at the central bank is to settle interbank
claims arising from the exchange of goods, services, and real and
financial assets. The overnight interest rate on such deposits is
an important element of monetary policy.
In the past, central banks imposed statutory reserve requirements to increase the stability and predictability of demand for
deposits at the central bank. Today, many central banks do not
impose such requirements; when they are imposed, the rates are
modest. The European Central Bank, for example, imposes a 2
percent requirement. The Federal Reserve imposes a graduated
set of requirements, depending on a bank’s deposits. In the United
States, however, retail deposit sweep programs have allowed many
banks to reorganize their balance sheet so they are unaffected by
statutory requirements.2 The demise of statutory reserve requirements was brought about largely by two factors. First, statutory
requirements place affected banks at a competitive disadvantage.
This was a minor issue when regulation limited the scope of competition among financial institutions, as the requirements’ cost
tended to be offset by the economic rent created by regulation.
Second, statutory reserve requirement systems tend to be expensive to administer; they require collection of large amounts of

data and careful monitoring of the eligible assets that banks
The remuneration rate provides an alternative tool for a central
bank to manage the demand for deposits held by banks at the
central bank. The experience of non-U.S. central banks suggests
two things: (i) a relatively high elasticity of demand for such
deposits with respect to the gap between the remuneration rate
and the target policy rate; and (ii) the potential for a small (or zero)
gap to increase the smooth operation of a nation’s payment system.
Deposits doubled at the Reserve Bank of New Zealand when it
reduced the gap to near zero. As a benefit, its payment system
operated more smoothly: The larger quantities of deposits at the
Reserve Bank eased timing mismatches of payments among
banks. In addition, day-to-day variation in overnight interest
rates decreased. For many central banks, minimizing daily variation in overnight rates increases the predictability of the cost of
payment-settlement funds and is an important ingredient in a
smoothly functioning payment system.
The Federal Reserve currently is prohibited by law from paying explicit interest on deposits held at the Federal Reserve, a
prohibition that will end in 2011. The Wall Street Journal reported
on May 7, 2008, that the Board of Governors recently initiated
discussions with Congress to end the prohibition sooner, perhaps
by year-end. Today, approximately 60 percent of these deposits are
not remunerated, and 40 percent are remunerated at a rate somewhat less than the federal funds rate. These latter deposits are ones
that banks have voluntarily agreed to maintain at the Federal
Reserve, in excess of any necessary to meet statutory reserve
requirements, to facilitate payments. Remuneration is paid in
“earnings credits,” which may be used to defray the cost of financial services purchased from the Federal Reserve. These credits
expire one year after issue and may not be converted into cash.
A more flexible remuneration environment likely would provide
the Federal Reserve a new, more flexible policy-implementation
tool similar to those of many other central banks. ■

Two excellent papers surveying these aspects of monetary policy are by Claudio
Borio: “A Hundred Ways to Skin a Cat: Comparing Monetary Policy Operating
Procedures in the United States, Japan and the euro area,” BIS Papers 9, December
2001; and “The Implementation of Monetary Policy in Industrial Countries:
A Survey,” BIS Economic Papers No. 47, August 1997.


Richard. G. Anderson and Robert. H. Rasche, “Retail Sweep Programs and
Bank Reserves, 1994-1999,” Federal Reserve Bank of St Louis Review, January/
February 2001, 83(1), pp. 51-72.

Views expressed do not necessarily reflect official positions of the Federal Reserve System.