New Wall St hot topic: Fed’s interest on reserves

* Some say cutting rate paid on reserves is a good tool

* Less apparent interest in Washington than on Wall Street

* Money funds could get hurt if Fed cuts rate on reserves

By Emily Flitter

NEW YORK, Oct 26 (BestGrowthStock) – Wall Street is hotly
anticipating the start of another round of U.S. debt purchases
by the Federal Reserve, but some investors are already looking
past the likely Fed announcement, wondering whether to plan for
other central bank options to boost the recovery.

While the Fed’s second round of quantitative easing efforts
will most likely begin with a Treasury purchase program, the
idea that the Fed should reduce or eliminate the interest it
pays on deposits held in reserve is enjoying a renaissance on
parts of Wall Street.

The Fed began paying interest on excess reserves two years
ago to try to control more tightly the real interest rate
compared with its fed funds target rate. Banks with cash
reserves at the Fed currently earn 25 basis points on those
deposits.

“In our view, the cost-benefit analysis of a cut in the
interest on excess reserves rate is becoming more favorable,”
wrote Jim Lee, head of futures strategy at RBS Securities in
Stamford, Connecticut, in a note to clients.

“We would not be surprised to see the Fed opt to slash the
rate in the coming months.”

With short-term interest-rates at historic lows, the Fed’s
25 basis-point interest rate looks like a comfortable spot, and
banks are not motivated to do much with their cash beyond
hoarding it at the central bank.

Some economists argue that if the Fed were to reduce or
eliminate interest payments on reserves, banks would put their
money to work in other ways, such as new loans or real assets.
They say such moves would be a more effective way to stimulate
economic growth — the ultimate goal of quantitative easing —
than Treasury purchases.

“Academic economists tend to like it because they think
this will somehow flush out the $1 trillion in excess
reserves,” said Lou Crandall, chief economist at Wrightson ICAP
in New York.

But he said he did not think the move was likely in the
current environment, in which the U.S. economic recovery looks
sluggish but not entirely stalled.

“If we appear to be falling into a double dip, that would
be one of the five things the Fed would do as part of the next
‘kitchen sink’ strategy,” Crandall said.

Indeed, interest in the move seems to be stronger in New
York than in Washington. During a recent spate of public
appearances here, Fed officials fielded audience queries about
the potential move, even though the last official mention of it
came in a speech Fed Chairman Ben Bernanke gave at the Fed
gathering in Jackson Hole, Wyoming, in August.

RBS’ Lee said such a move would lead investors to take more
risks on longer-dated Treasuries and credit instruments and
suggested ways to trade on it.

“If it happens, we should see bull flattening of yield
curve and compression of credit spreads,” he wrote in his note
on Monday. “We suggest a number of trades that would benefit
should the interest on excess reserves rate be cut, or a limit
be placed on the amount of excess reserves allowed.”

Other investors say they have contemplated the scenario,
though they have not acted on it.

“We thought about it,” said Thanos Bardas, a portfolio
manager at Neuberger Berman Fixed Income in Chicago, a firm
with approximately $70 billion in fixed income assets under
management.

Economists and strategists on Wall Street are almost
certain that the Fed will announce another program to purchase
Treasuries after its next Federal Open Market Committee Meeting
ends on Nov. 3. But questions remain as to whether more
Treasury purchases will have the desired effect, since Treasury
yields are so low already.

In response to questions on the topic during their
appearances last week, Dallas Fed President Richard Fisher and
Fed Governor Elizabeth Duke each acknowledged that cutting the
interest rate on reserves was a tool the Fed could potentially
use. But they did not give any indication that it was being
seriously discussed as a policy move.

Philadelphia Fed President Charles Plosser said on Friday
that the move could disrupt short-term funding markets.

Money-market funds, already searching for high-quality
places to put investors’ cash, would be hurt, investors argue,
if interest rates fell any lower than they are now. The
potential damage to money market funds is one of the biggest
reasons why the Fed might try to avoid cutting the interest
rate on excess reserves.

“If you do quantitative easing that is further out on the
curve and it’s steeper, you can get more benefits in terms of
lowering the private sector borrowing costs,” Bardas added.
(Editing by Dan Grebler)

New Wall St hot topic: Fed’s interest on reserves