Fed Weighs Interest on Reserves as New Benchmark Rate

By Scott Lanman

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 target.

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 meltdown.

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.”

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