Fed Raises Rate It Pays on Banks' Reserve Balances

By Scott Lanman

Oct. 22 (Bloomberg) -- The Federal Reserve will raise the interest rate it pays banks for the excess cash they keep on deposit so it can keep pumping funds into the financial system without affecting the central bank's monetary policy.

Fed officials acted after the initial rate they set Oct. 6 failed to keep the benchmark U.S. overnight interest rate close to the target set by policy makers. The central bank will pay interest on excess reserves at the lowest target rate for a one- or two-week period less 0.35 percentage point, effective tomorrow, the Fed said in a statement.

The previous rate was 0.75 percentage point below the target. Chairman Ben S. Bernanke wants to ensure that his efforts to flood the financial system with cash don't interfere with the policy rate. The Fed started paying interest on reserves this month after gaining authorization under the financial-rescue bill passed by Congress.

``We're not quite sure what we have to pay in order to get the market rate, which includes some credit risk, up to the target,'' Bernanke told economists Oct. 7. ``We're going to experiment with this and try to find what the right spread is.''

The federal funds rate on overnight loans between banks traded as low as 0.25 percent this week and 0.13 percent last week. Fed officials cut their target for the benchmark rate by a half point to 1.5 percent on Oct. 8.

Fed governors ``judged that a narrower spread between the target funds rate and the rate on excess balances at this time would help foster trading in the funds market at rates closer to the target rate,'' the Fed said today in Washington.

To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net