The Federal Reserve Board on October 22 announced that it would alter the formula it uses to determine the interest rate paid to depository institutions on excess reserve balances.

Initially, the rate on excess balances had been set at 75 basis points below the lowest federal funds rate target established by the Federal Open Market Committee (FOMC) in effect during the relevant reserve maintenance period. Under the new formula, the rate on excess balances will be set at 35 basis points below the lowest FOMC target rate in effect during the reserve maintenance period.

This change took effect for the maintenance periods beginning Thursday, October 23.

The Emergency Economic Stabilization Act of 2008 allowed the Fed to begin paying interest on reserves on October 1, 2008. The Board had quickly amended its Regulation D (Reserve Requirements of Depository Institutions) to direct the Federal Reserve Banks to pay interest on both required and excess reserve balances. Now the Fed has changed the rate it pays on excess balances, while leaving the rate for required balances unchanged.

The Fed said it made this change because it believes that a narrower spread between the target funds rate and the rate on excess balances would help foster trading in the funds market at rates closer to the target rate.

The Fed said it would continue to evaluate the appropriate setting of the rate on excess balances “in light of evolving market conditions” and make further adjustments as needed.