Dig up Uncle Milt, I want to talk to him

Moneyess: George Selgin had an interesting post describing how the Fed appears to be breaking the law by paying too much interest to reserve-holders. This is an idea that's cropped up on the blogosphere before, here is David Glasner, for instance.
I agree with George that the the letter of the law is being broken. That's unfortunate. As Section 19(b)(12)(A) of the Federal Reserve Act stipulates, the Fed can only pay interest "at a rate or rates not to exceed the general level of short-term interest rates." With three month treasury bills currently around 0.33% and the fed funds rate at 0.4%, the current interest rate on reserves (IOR) of 0.5% exceeds the legal maximum.
Unlike George, I don't think the Fed deserves criticism about this. If the letter of the law is being broken, the spirit of the law surely isn't.
If there is a spirit residing in the law governing IOR, it's the ghost of Milton Friedman. Since the Fed's inception in 1913, IOR had been effectively set at 0%, far below the general level of short term interest rates. This has acted as a tax on bankers. They have been forced to hold an asset—reserves—that provided a below-market return. Friedman's big idea was to remove this distortionary tax by bringing IOR up to the same level as other short term interest rates. Banks would now be earning the same rate as everyone else. The Fed would only get the authority to set IOR in 2008, long after most modern central banks like the Bank of Canada had implemented Friedman's idea.
Friedman wanted to remove the tax, but he didn't want to introduce a subsidy in its place. To prevent central bank subsidization of banks, the Federal Reserve Act is explicit that IOR should not exceed other short-term interest rates.

IOR (  and interest on loans) are the short term rates, and member banks set that rates, ex post facto, by their collective actions, they are the market rate by definition.  There can be no other way, the central bank is distributing the lightest weight good, it better be the fastest adapter..

It was Milt who said that a rate change reflects an imbalance from the past, so in the overlap, folks in the past will take a retrograde gain or loss.  The central bank does not subsidize the member banks, together they discover the natural rate, and that discovery requires a certain amount of float, or currency at risk.

When the central banks probability of loss exceeds a threshold, it will reset the lending tree from the point of excess down to the leaves along that branch.  Currtency bankers losses should be set to match the published precision.

The Moneyness guy goes on:

In practice, how might the Fed set IOR in a way that subsidizes banks? This is tougher then it seems. If the Fed sets IOR at 1%, arbitrage dictates that all other short term rates will converge to that same level. After all, why would a financial institution buy a safe short term fixed income product for anything less than 1% if the central bank is fixing the yield of a competing product, reserves, at 1%? 

It cannot subsidize the member banks, member banks subsidize themselves by finding innovations that can be monetized.  No one knows short term rates until they are set ex post facto.  But wait, how can we borrow money if we do not know the interest rate?   Because the borrowers, depositers,  do not know current short term rates, if they know them they would not need bankers!  Bankers deal with rate uncertainty, in the present.  The economy adapts the real yield curve as a perturbation of the nominal curve, which is generally one rate hike old.