Fed Would Gain More Power Over Short-Term Rates in Rescue Bill

By Craig Torres and Scott Lanman

Sept. 29 (Bloomberg) -- The Federal Reserve would gain more power over short-term interest rates as part of Congress's $700 billion legislation to revive credit markets, making it easier for the Fed to pump funds into the banking system.

The draft bill, released yesterday, gives the Fed authority as of Oct. 1 to pay interest on reserves held at the central bank by financial institutions. That would encourage banks to deposit excess funds with the Fed rather than dumping them into the money markets and distorting its overnight federal funds rate.

The flood of liquidity pumped into the financial system by the Fed to encourage interbank lending over the past year has made it harder for the central bank to gauge market conditions and keep fed funds at its 2 percent target. The rate has traded between zero and 7 percent since Sept. 15.

``It's probably a good thing,'' said Marvin Goodfriend, a former senior policy adviser at the Richmond Fed who is now professor of economics at Carnegie Mellon University in Pittsburgh. Allowing payment of interest on reserves will ``enable the Fed to have credit policy that's independent of its monetary policy,'' he said.

While containing the interest provision sought by Fed Chairman Ben S. Bernanke since May, the draft legislation increases congressional scrutiny of the Fed's emergency loans in connection with the collapses of Bear Stearns Cos. and American International Group Inc.

Report to Congress

The bill requires the central bank to submit reports to Congress on loans to nonbanks since March 1 as well as updates at least every two months while the loans are outstanding.

The Federal Open Market Committee sets a target for the federal funds rate, which the New York Fed is obligated to achieve on a daily basis through temporary and permanent purchases or sales of bonds in the open market. Banks are required to hold a proportion of their customers' deposits in an account at the central bank.

Paying interest on reserves puts a ``floor'' under the traded overnight rate, which would allow a central bank ``to provide liquidity during times of stress'' without affecting the rate, New York Fed economists said in a paper last month. New Zealand's central bank has adopted such an approach.

The Fed had already received authority in 2006 to start paying interest on reserves in October 2011. Bernanke asked House Speaker Nancy Pelosi in May to expedite the authority. U.S. lawmakers are reviewing the $700 billion plan to buy troubled assets from financial institutions, and the House and Senate may vote tomorrow.

New Date

The draft legislation doesn't mention the Fed in the three- line section that would provide the interest-payment authority. The bill says that the part of the 2006 law giving the Fed the power ``is amended by striking `October 1, 2011' and inserting `October 1, 2008'.''

In 2006, the Congressional Budget Office estimated that Fed interest payments would cost the government $1.4 billion in the first five years.

``I expect them to use it to manage the funds rate more efficiently,'' said Lou Crandall, chief economist at Wrightson ICAP LLC, in Jersey City, New Jersey.

A measure of availability of cash among banks, known as the Libor-OIS spread, widened to 2.08 percentage points, the most on record, on Sept. 26. In the year before the credit crisis started in August last year, the spread averaged 8 basis points.

Commercial banks borrowed $39.4 billion from the Fed's discount window for the week ending Sept. 24, almost double the previous period, as the financial crisis deepened and funding from other banks dried up.

Counterparty fears also increased in the wake of Lehman Brothers Holdings Inc.'s bankruptcy filing on Sept. 15.

To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.net; Scott Lanman in Washington at slanman@bloomberg.net.