In 2016, the Federal Reserve will pay at least $12.2 billion to U.S. and foreign banks to keep the money created via its quantitative easing programs out of the economy. If the Fed raises rates as expected next year, the amount nearly doubles to $23.1 billion.
From 2008 to 2015, the Fed purchased over $4 trillion worth of bonds to stimulate growth in the economy. Risk markets responded, as is demonstrated by the close correlation between the S&P 500 and growth of the Fed’s balance sheet through its bond purchases.
To sterilize the vast sums of money that would otherwise circulate throughout the economy and cause price inflation, the Fed pays an above-market interest rate of 0.50% to banks on reserves, or digital cash, held at the Fed. Currently, banks are holding $2.5 trillion at the Fed and are paid $34.5 million per day in interest.
The Fed has telegraphed its intent to raise rates in 2016, and analysts expect two to four rate hikes. Assuming the Fed raises rates four times‑-once at each of the meetings that are accompanied by a press conference--payments to banks at the end of 2016 would amount to $103.6 million per day.
In addition to paying interest on reserves, the Fed conducts daily auctions to drain cash from the economy and maintain a floor on short-term interest rates. These reverse repo operations pay 0.25% and have averaged $154 billion per day since the Fed raised rates on December 16.
The interest paid by the Fed to banks and funds that participate in the operations amounts to $1.06 million per day. If the Fed raises rates as expected in 2016, total payments would be $1.03 billion in 2016, which is in addition to the $23.1 billion paid as interest on reserves.
After six years of near-zero interest rates, the Fed is in uncharted territory. Never before has a central bank attempted to raise rates after having provided so much stimulus and expanding its balance sheet to such a degree. The legacy of the Fed’s quantitative experiment is largess to banks and funds that will likely total $24 billion in 2016.