Bailout bill gives Fed new tool to boost liquidity

WASHINGTON (Reuters) - The U.S. Federal Reserve gained a key tactical tool from the $700 billion financial rescue package signed into law on Friday that will help it channel funds into parched credit markets.

Tucked into the 451-page bill is a provision that lets the Fed pay interest on the reserves banks are required to hold at the central bank. The Fed is expected to provide details of the facility next week.

To restore flows of borrowing and credit impaired by mortgage defaults and mounting mistrust of financial institutions, the Fed has flooded markets with an unprecedented flow of funds through auctions and lending facilities. On Monday, the Fed expanded currency swap lines with central banks around the world to $620 billion and boosted the size of its short-term auctions to $75 billion.

"This change would greatly increase the ability of the Fed to expand the size of its existing liquidity facilities," Michael Feroli, an economist at JPMorgan Economics in New York, wrote in a note to clients this week.

That ability could help unstick clogged credit markets, where interbank lending has been practically at a standstill. Key benchmark rates for the banking industry climbed this week. One gauge -- the premium to borrow at the London interbank offered rates over anticipated policy rates, as measured by average Overnight Index Swap rates -- blew out to almost 3 percentage points, a historic high.

U.S. banks must meet reserve requirements that are set in law. But since they receive no interest on the reserves they hold at the central bank, they have incentive to lend out any excess cash in the open market, which pressures interest rates lower.

With the ability to pay interest on reserves, the Fed can put a floor under benchmark overnight rates, which are currently at 2 percent. Banks would park excess funds at the Fed any time interest rates break below the amount the central bank was willing to pay.

The bill, which the House of Representatives approved on a 263-171 vote, is silent on the question of what interest rate the Fed would pay and whether it might be slightly above or below the prevailing interbank federal funds rate that the central bank uses as its main lever to influence the economy.

"Instead of banks hoarding liquidity, they can give it to the Fed," said Torsten Slok, an economist for Deutsche Bank Securities in New York. "The Fed will start to act as an intermediary between banks."

When the Fed targets a particular level for interbank lending, it sells or buys Treasuries to influence demand for money, and thus rates.

To revive lending markets frozen by fears over tainted mortgage-related assets buried in complex securities, the Fed has pushed out hundreds of billions of dollars. For details see

As it provides liquidity, the Fed has to offset its cash infusions by selling Treasuries to hold interest rates near its target. If the Fed no longer had enough Treasuries to offset its liquidity provisions, interest rates would fall to zero.

As fed funds dipped below the 2 percent target this week, the Fed drained at least $50 billion in temporary reserves from the banking system from Wednesday through Friday.

The ability to pay interest on reserves will help the Fed manage its target rate more effectively, Slok said.

In placid markets, the Fed can easily target the federal funds rate. But because of recent turbulence, reserve management has been difficult and the effective funds rate has swung widely over the course of each day.

(Reporting by Mark Felsenthal; Editing by Dan Grebler)