January 26, 2010

(BN) Fed Officials Consider Adopting Interest on Reserves as New Benchmark Rate

I'm not sure what to make of this my brain is still wrapping itself
around this idea. My first blush response is that it will be positive
for the dollar. But it could get complicated and make the overall
economic recovery a little messier as banks adjust prime rates.
Fed Weighs Interest on Reserves as New Benchmark Rate

Jan. 26 (Bloomberg) -- Federal Reserve policy makers are considering
adopting a new benchmark interest rate to replace the one they've
used for the last two decades.

The central bank has been unable to control the federal funds rate
since the September 2008 bankruptcy of Lehman Brothers Holdings Inc.,
when it began flooding financial markets with $1 trillion to prevent
the economy from collapsing. Officials, who start a two-day meeting
today, have said they may replace or supplement the fed funds rate
with interest paid on excess bank reserves.

"One option you might want to consider is that our policy rate is the
interest rate on excess reserves and we let the fed funds rate trade
with some spread to that," Richmond Fed President Jeffrey Lacker told
reporters on Jan. 8 in Linthicum, Maryland.

The central bank needs to have an effective policy rate in place when
it starts to raise interest rates from record lows to keep inflation
in check, said Marvin Goodfriend, a former Fed economist. Policy
makers are concerned that the Fed funds rate, at which banks borrow
from each other in the overnight market, may fail to meet the new
target, damaging their credibility and their ability to control
inflation as the economy recovers.

'Extended Period'

The choice of a benchmark is the "front line of defense against
inflation, and also it's at the heart of the central bank being able
to precisely and flexibly guide interest-rate policy in the
recovery," said Goodfriend, now a professor at Carnegie Mellon
University in Pittsburgh.

The Federal Open Market Committee is likely to maintain its pledge to
keep interest rates "exceptionally low" for an "extended
period" in a statement at about 2:15 p.m. tomorrow, economists said.
The Fed probably won't raise interest rates from record lows until
the November meeting, according to the median of 51 forecasts in a
Bloomberg survey of economists this month.

Fed Chairman Ben S. Bernanke, in July Congressional testimony, called
interest on reserves "perhaps the most important" tool for
tightening credit.

Inflation Concerns

Banks' excess reserves, or deposits held with the Fed above required
amounts, totaled $1 trillion in the two weeks ended Jan. 13, compared
with $2.2 billion at the start of 2007. The Fed created the reserves
through emergency loans and a $1.7 trillion purchase program of
mortgage-backed securities, federal agency and Treasury debt.

By raising the deposit rate, now at 0.25 percent, officials reckon
banks will keep money at the Fed and not stoke inflation by lending
out too much as the economy recovers.

The new policy may be similar to what the Bank of England does now,
said Philip Shaw, chief economist at Investec Securities in London.
The U.K. central bank's benchmark interest rate, now at 0.5 percent,
is the rate it pays on the reserves it holds for commercial banks. It
may drain excess liquidity from the system by selling back the gilts
it has purchased through its so-called quantitative easing program,
Shaw said.

Communications Strategy

Policy makers will need to adopt a communications strategy to explain
the new benchmark because "people might have had a hard time getting
their mind around the idea that the official rate had become the
interest on reserves rate," said Kenneth Kuttner, a former Fed
economist who has co-written research with Bernanke and now teaches at
Williams College in Williamstown, Massachusetts.

Without a federal funds target, banks might have to find a new way to
set the prime borrowing rate, the figure most familiar to consumers
that that is now pegged at three percentage points above the fed funds

In the past, the Fed had controlled the rate by buying or selling
Treasury securities, adding or withdrawing cash from the system. That
mechanism broke down when the Fed started flooding the system with
cash after the bankruptcy of Lehman Brothers to prevent a financial

The deposit rate would help set a floor under the fed funds rate
because the Fed would lock up funds by offering a fixed rate of
interest for a defined period and prohibiting early withdrawals.

'Risk Free'

"In general, banks will not lend funds in the money market at an
interest rate lower than the rate they can earn risk-free at the
Federal Reserve," Bernanke said in an October speech in Washington.

The New York Fed has been testing another tool, reverse repurchase
agreements, as a way of pulling cash out of the financial system. In
that case, the Fed would sell securities and buy them back at an
agreed-upon later date.

There could be complications to using the deposit rate. Banks may be
able to generate more revenue by lending at prime rate rather than by
earning interest at the Fed, said William Ford, a former Atlanta Fed
president at Middle Tennessee State University in Murfreesboro.

Also, the Fed's direct control over a policy rate --instead of
targeting a market rate -- could skew trading and financing toward
short-term borrowing once investors know the rate won't change
between Fed meetings, said Vincent Reinhart, a former Fed monetary-
affairs director.

The new reliance on reserve interest could also increase the policy
clout of Fed governors in Washington at the expense of the 12 regional
Fed bank presidents, Reinhart said.

Congress gave only the Fed governors the authority to set the deposit
rate. The presidents have historically favored higher rates and voiced
more concern about inflation.

"The Federal Reserve Act puts a very high weight on comity," said
Reinhart, now a resident scholar at the American Enterprise Institute
in Washington. Using interest on reserves for setting policy "can
change the tenor of the discussions, and I don't know how they get
around it."

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