The Fed pays interest to banks to control how much money flows through the economy
The Federal Reserve — the central bank of the United States — pays interest on the money that banks deposit with it. This might sound backwards: normally you pay a bank to hold your money, not the other way around. But the Fed does this deliberately, as a tool to manage the entire financial system. When the Fed raises the interest rate it pays, banks are more likely to hold money rather than lend it out. When it lowers the rate, banks have more reason to lend. By adjusting this one number, the Fed influences whether the economy speeds up or slows down.
Think of it this way: banks are in business to make money by lending. If the Fed pays them 5% just to sit on deposits, banks will do less lending because they can earn money without taking the risk of a loan going bad. If the Fed pays almost nothing, banks will push harder to lend money out, because that is where the profit is. The Fed uses this lever constantly, raising and lowering the rate based on what is happening in the economy.
Key Takeaways
- The Federal Reserve pays interest on the reserves that banks are required to hold, using this rate to influence how much banks lend.
- When the Fed raises this interest rate, banks lend less and money becomes scarcer and more expensive, which slows inflation.
- When the Fed lowers this rate, banks lend more freely, which puts more money into the economy and can boost growth.
- The interest rate the Fed pays is separate from the interest rates you see advertised for savings accounts or mortgages, though it influences those too.
Reserve requirements and why banks hold money at the Fed
Banks are required by law to keep a certain amount of money on hand at all times — they cannot lend out every dollar that customers deposit. This money is called a reserve, and most of it sits in an account at the Federal Reserve. The Fed is essentially the bank's bank: just as you might keep money at a local bank, banks keep money at the Fed.
Because banks are required to hold these reserves, they cannot use that money to make loans or investments that would earn them profit. The Fed compensates them for this by paying interest on those reserves. Without that interest, banks would be forced to hold money that earns them nothing, which would cut into their profits and potentially make banking less stable.
How the Fed's interest rate affects lending and borrowing
The interest rate the Fed pays on reserves is called the interest on reserve balances, or IORB. It is one of the main tools the Fed uses to steer the economy. When inflation is high — meaning prices are rising too fast — the Fed raises this rate. Banks then find it more attractive to hold money at the Fed rather than lend it out. Less lending means less money chasing goods and services, which helps bring prices down.
When the economy is weak and unemployment is high, the Fed lowers this rate. Banks earn less by sitting on reserves, so they push harder to lend money to businesses and consumers. More lending means more money in people's pockets, more spending, and more hiring. The Fed adjusted this rate dramatically during the 2008 financial crisis and again during the COVID-19 pandemic, lowering it nearly to zero to encourage as much lending as possible.
This Fed rate is not the same as the interest rate your bank offers you on a savings account, but it influences it. When the Fed pays banks more interest on their reserves, banks can afford to pay you more interest on your savings. When the Fed lowers its rate, your savings account interest typically falls too.
The difference between the Fed's rate and other interest rates you encounter
The interest rate the Fed pays on reserves is a wholesale rate — it applies to the massive amounts of money that banks hold, not to individual customers. It influences the broader financial system but is not the rate you see when you shop for a mortgage or open a savings account.
However, the Fed's rate sets the tone for all other rates. When the Fed raises the interest on reserve balances, it becomes more expensive for banks to borrow money from each other, which makes them charge more to lend to you. When the Fed lowers its rate, borrowing becomes cheaper, and banks lower the rates they offer to customers. This is why news reports about the Fed's decisions affect mortgage rates, credit card rates, and savings account rates within weeks or months.
How the Fed actually pays this interest
The Fed does not send checks to banks. Instead, it credits the interest directly to the reserve accounts that banks maintain at the Federal Reserve. If a bank holds $100 million in reserves and the Fed is paying 5% annual interest, the Fed adds $5 million to that bank's account over the course of a year. The bank can then withdraw that money or leave it sitting there.
This system is entirely electronic and happens automatically. Banks do not have to do anything to receive the interest — it accrues straightforward because they are holding reserves. The Fed adjusts the rate it pays whenever its policy committee meets, which happens roughly every six weeks.
Why this matters to you even if you never deal with the Fed directly
You do not interact with the Federal Reserve as a customer, but its decisions affect your financial life constantly. When the Fed raises interest rates, the cost of borrowing goes up — mortgages, car loans, and credit cards all become more expensive. When the Fed lowers rates, borrowing becomes cheaper. The interest you earn on a savings account or money market fund moves in the same direction.
The Fed's interest rate decisions also influence whether you can find a job. When the Fed raises rates to fight inflation, it intentionally slows the economy, which can lead to layoffs. When it lowers rates to boost growth, unemployment typically falls. Understanding that the Fed uses interest rates as a tool to manage the whole economy helps explain why financial news matters to your own situation.
What happens when the Fed's rate is very high or very low
When the Fed pays very high interest on reserves — as it has in recent years to fight inflation — banks have a strong incentive to hold money rather than lend. This can make it harder for small businesses to borrow and can slow down the housing market. On the other hand, it protects savers: if you have money in a savings account, you earn more interest when the Fed's rate is high.
When the Fed's rate is very low or near zero, the opposite happens. Banks have little reason to hold reserves, so they lend aggressively. This makes borrowing cheap and straightforward, which can boost the economy but can also lead to excessive borrowing and inflation. Savers suffer because savings accounts earn almost nothing.
The Fed tries to find a middle ground — a rate high enough to discourage excessive lending and inflation, but low enough to keep credit available and the economy growing. This balancing act is one of the most important jobs in the financial system.
Frequently Asked Questions
Does the Fed pay interest to regular people who have accounts there?
No. The Federal Reserve does not have customer accounts for individuals. You cannot open a savings account or checking account at the Fed. The interest the Fed pays is only for banks and certain other financial institutions that hold reserves there.
Where does the Fed get the money to pay this interest?
The Fed creates money as part of its role as the central bank. It also earns income from the investments it holds and from fees it charges banks for services. The interest it pays to banks comes from these sources.
Can the Fed pay negative interest to force banks to lend?
Technically yes, though the Fed has never done this in the United States. Some central banks in Europe have experimented with negative rates, which would mean banks lose money by holding reserves. In theory, this would force banks to lend rather than hold cash, but it is controversial and can have unintended consequences.
How often does the Fed change the interest rate it pays?
The Fed's policy committee meets roughly every six weeks to decide whether to raise, lower, or hold steady the interest rate on reserves. Changes are announced publicly, and the new rate usually takes effect within days. The Fed does not change rates on a fixed schedule — it responds to economic conditions.
If banks earn interest from the Fed, why do they charge me interest on loans?
Banks earn interest on reserves, but they also have costs: they pay employees, maintain buildings, handle fraud, and deal with loans that go bad. The interest they charge you on loans has to cover all those costs plus provide profit. The interest from the Fed is just one small piece of a bank's income.