The Fed pays banks interest to control how much money moves through the economy
The Federal Reserve pays interest on the money that banks hold in reserve accounts at the Fed. This interest rate—called the interest on reserve balances, or IORB—is one of the Fed's main tools for managing inflation, employment, and economic growth. When the Fed raises this rate, banks are incentivized to hold more money rather than lend it out, which slows down spending. When the Fed lowers the rate, banks have less reason to sit on cash and are more likely to lend, which speeds up spending.
This mechanism matters to you because it affects how much interest your bank pays on savings accounts, how much you pay on loans, and whether jobs are easy or hard to find. The Fed does not set these rates directly—your bank decides what to pay you—but the Fed's rate is the floor that influences all the others.
Key Takeaways
- The Federal Reserve pays interest on reserve balances to give banks a reason to hold money at the Fed instead of lending it all out immediately.
- When the Fed raises this rate, banks lend less and the economy slows; when it lowers the rate, banks lend more and the economy speeds up.
- The Fed uses this tool to fight inflation when prices are rising too fast, and to support employment and growth when the economy is weak.
- Changes to the Fed's interest rate eventually affect the rates your bank offers on savings accounts and charges on mortgages and car loans.
How banks use the Fed's interest rate to decide what to do with money
Banks receive deposits from customers and businesses. They can do three things with that money: lend it out, invest it, or hold it in an account at the Federal Reserve. If the Fed is paying 5% interest on reserve balances, a bank might decide that holding money at the Fed is safer and more predictable than lending it to a risky borrower at 6%. The higher the Fed's rate, the more attractive it becomes to just sit tight.
This is the whole point. The Fed is not trying to make banks rich. It is trying to influence how much lending happens in the real economy. When inflation is high and prices are rising too fast, the Fed raises its interest rate to make holding reserves more attractive than lending. Fewer loans means less spending, which brings prices down. When unemployment is high and the economy is weak, the Fed lowers its rate to make lending more attractive than holding reserves. More loans means more spending, which creates jobs.
The difference between the Fed's rate and the rates you see at your bank
The interest rate the Fed pays on reserve balances is not the same as the rate your bank pays you on a savings account. The Fed's rate is the wholesale rate—the rate banks pay each other and the rate the Fed pays banks. Your bank's savings rate is the retail rate—what your bank decides to pay you.
Banks use the Fed's rate as a reference point. If the Fed is paying banks 5% to hold reserves, your bank knows it could earn that 5% by simply parking your deposit at the Fed. So your bank will offer you something less—maybe 4.5% or 4%—and pocket the difference. The wider the gap, the more profit your bank makes. When the Fed raises its rate, banks usually raise yours too, but not by the same amount. When the Fed cuts its rate, banks cut yours faster.
Why the Fed needs banks to hold money in reserve
Banks are required by law to hold a certain amount of cash in reserve—money they cannot lend out. This reserve requirement exists so that if many customers withdraw money at once, the bank has cash on hand to pay them. The Fed holds these reserves in accounts at the Federal Reserve building.
But banks hold more than the legal minimum. They hold extra reserves because they need a buffer for unexpected withdrawals, because regulators expect it after the 2008 financial crisis, and because they want to be ready to lend when good opportunities come along. The Fed's interest rate on reserves is the incentive that makes banks willing to hold this extra money instead of putting it to work elsewhere.
What happens when the Fed changes its interest rate
The Federal Reserve's policy committee meets eight times a year to decide whether to raise, lower, or hold steady the interest rate on reserve balances. When they raise it, banks immediately earn more on their reserves, so they have less reason to lend aggressively. When they lower it, banks earn less, so they hunt harder for lending opportunities.
These changes ripple outward. Within days or weeks, banks adjust the rates they offer on savings accounts, money market accounts, and certificates of deposit. Within weeks or months, they adjust rates on mortgages, car loans, and business loans. Within months, the effects show up in hiring, spending, and inflation. A single change to the Fed's rate can take six months to a year to fully work through the economy.
The relationship between the Fed's rate and inflation
When inflation is high—meaning prices are rising faster than normal—the Fed raises its interest rate on reserves. This makes holding money at the Fed more attractive than lending it out. Banks lend less, businesses borrow less, consumers spend less, and prices stop rising so fast. This is painful in the short term because it slows hiring and can push the economy toward recession, but it is the tool the Fed uses to prevent inflation from spiraling out of control.
When inflation is low and the economy is weak, the Fed lowers its rate on reserves. This makes holding money at the Fed less attractive, so banks lend more aggressively. Businesses borrow and expand, consumers borrow and spend, and the economy grows. More jobs open up. This is the opposite problem—the Fed is trying to stimulate growth, not cool it down.
Why this matters to your financial decisions
The Fed's interest rate on reserves is not something you interact with directly, but it shapes every financial decision you make. If the Fed is raising rates, your savings account will eventually pay more interest, but your mortgage or car loan will also cost more. If the Fed is cutting rates, your savings will earn less, but borrowing becomes cheaper. The timing is unpredictable—sometimes changes happen within weeks, sometimes it takes months—so watching the Fed's announcements can help you decide when to lock in a mortgage rate or move money into a high-yield savings account.
The Fed publishes its interest rate decision and the reasoning behind it on its website after each meeting. Financial news outlets cover these announcements the same day. If you are planning a major purchase or refinance, checking the Fed's recent moves and forward guidance can help you understand whether rates are likely to go up or down in the coming months.
Frequently Asked Questions
Does the Fed pay interest to all banks the same way?
Yes, the Fed pays the same rate on reserve balances to all banks that hold accounts at the Federal Reserve. However, only banks with accounts at the Fed receive this interest. Most community banks and credit unions do not hold accounts directly at the Fed, so they do not receive this interest. Instead, they hold reserves at larger correspondent banks, which may or may not pass along the Fed's rate.
Can the Fed's interest rate go negative?
The Fed has never set its interest rate on reserve balances below zero, but some central banks in Europe and Japan have experimented with negative rates. A negative rate would mean banks pay the Fed to hold their money, which would force them to lend more aggressively. The Fed has said it prefers other tools to negative rates.
What happens if banks ignore the Fed's interest rate and lend anyway?
Banks are free to lend as much as they want, regardless of the Fed's rate. However, if the Fed's rate is high, lending becomes less profitable than holding reserves, so banks naturally lend less. The Fed's rate is an incentive, not a command. Banks respond to it because it affects their bottom line.
How often does the Fed change its interest rate on reserves?
The Fed's policy committee meets eight times per year to review economic conditions and decide whether to change the interest rate on reserve balances. The committee may raise, lower, or hold the rate steady at each meeting. Between meetings, the rate stays the same. The Fed announces its decision immediately after each meeting.
If the Fed raises its rate, will my bank raise my savings rate right away?
Not necessarily. Banks usually raise savings rates within a few weeks of a Fed increase, but the timing varies. Some banks raise rates immediately to attract deposits, while others wait weeks or months. The amount they raise also varies—banks often raise savings rates by less than the Fed's increase, keeping the difference as profit. Shopping around for high-yield savings accounts can help you find banks that pass along more of the Fed's rate to customers.