Fed unlikely to lower rate it pays on bank reserves

By Pedro Nicolaci da Costa

WASHINGTON (BestGrowthStock) – Federal Reserve officials like to say they have plenty of tools left in their policy arsenal to deal with a weakening economy.

Yet one such instrument seems to have been stashed away for good: the Fed’s ability to lower the interest it pays on banks’ excess reserves.

Policymakers believe the potential costs of bringing the rate, currently at 0.25 percent, all the way to zero outweigh the minuscule stimulative benefits such a move might have on financial conditions.

“It’s kind of a dead-end policy, you can only do it once,” James Bullard, president of the Federal Reserve Bank of St. Louis, told reporters after a speech in Arkansas last week. “I don’t think it would be particularly effective.

Officials fear that money market funds could see a drying up of liquidity as happened during the financial meltdown.

The Fed’s decision earlier this month to offer further stimulus to a flagging economy by channeling the proceeds from maturing mortgage bonds in its portfolio into the Treasury bond market suggests Bullard is not alone in his thinking.

The central bank could have accomplished a similar effect — telling financial markets it was again in easing mode — by lowering the rate on excess bank reserves. Its decision not to do so indicates both reluctance about its possible consequences and heightened concern about the economy’s health.

It’s tough to argue that the policy would have no effect at all. Unlike asset purchases or quantitative easing, which works indirectly by expanding total credit available in the financial system, lowering the rate on reserves would have a very concrete, if modest, effect.

By stripping banks of this easy way to earn interest on their excess capital, the Fed might provide some boost to lending at a time when lack of credit availability is a major worry for economists.

Yet that possibility is not enough for policymakers to overcome their reservations. In 2008, as the financial crisis raged and the Fed brought rates to rock-bottom lows, a large money market fund saw the value of its shares dip beneath $1, the so-called breaking of the buck. Amid fears of contagion, the government was forced to step in.

“They think it’s going to get them that much bang for their buck,” said Richard Berner, chief U.S. economist at Morgan Stanley. “It would create more distortions than benefits.”

Interestingly, the newly minted rate was originally billed as a tool to withdraw monetary stimulus. During the financial crisis, Congress granted the central bank the authority to begin paying interest on reserves as a way to enhance its ability to, eventually, push official borrowing costs higher.

In response to the deepest recession since the Great Depression, the Fed not only slashed the fed funds rate, its key policy benchmark, effectively to zero, but also undertook a host of emergency lending measures to stem the credit crunch.

With Fed credit to the banking system now around a record $2.3 trillion, officials spent the early months of 2009 avidly debating an eventual exit strategy. Many saw the interest on excess reserves as a crucial element of that plan.

But as U.S. economic performance began to deteriorate in the second quarter of this year, officials started to think of this newly minted rate as a possible way to ease monetary conditions even further.

Now, however, the Fed’s signal that it stands ready to boost Treasury purchases even further if growth stalls all but supersedes any propensity to cut or eliminate the rate on bank reserves. In short, as a policy option, this is not the brightest tool in the shed.

“It has problems that make it unlikely to be deployed,” said David Resler, chief economist at Nomura Securities.

Fed unlikely to lower rate it pays on bank reserves