Cutting excess-reserves rate would not help: Fed economists

NEW YORK Mon Aug 27, 2012 11:28am EDT

NEW YORK (Reuters) - Economists at the Federal Reserve Bank of New York have poured cold water on a plan to lower interest rates on some bank deposits, an idea that had gained favor among a couple of policymakers at the U.S. central bank.

The idea of lowering the rate that the Federal Reserve pays banks for parking their reserves at the Fed received some attention this summer as a way to encourage the banks to do more lending to businesses and individuals, boosting the economy.

The strategy has been adopted in Europe. And the U.S. central bank - already stretched thin with rates low and a swelled balance sheet - is on the hunt for new tools to possibly ease monetary policy.

But in a research paper published Monday, New York Fed economists examined the structure of the Fed balance sheet and concluded that lowering the interest on excess reserves (IOER), from a rate of 0.25 percent currently, would have very little impact on the quantity of balances banks hold at the Fed.

Lowering "this interest rate to zero (or even slightly below zero) is unlikely to induce banks, firms, or households to start holding large quantities of currency," wrote Gaetano Antinolfi and Todd Keister.

"It follows, therefore, that lowering the interest rate paid on excess reserves will not have any meaningful effect on the quantity of balances banks hold on deposit at the Fed."

The New York branch is the most influential of the regional Fed banks, in part because it deals directly with Wall Street in conducting the Federal Reserve's open market activity.

Excess reserves are the funds held above the level needed to meet a financial institution's reserve requirement.

DEBATE OVER IOER

Federal Reserve Chairman Ben Bernanke and other Fed policymakers have aggressively eased monetary policy to battle the recession, including more than three years of ultra low interest rates and $2.3 trillion in asset purchases.

But with U.S. economic growth still slow and unemployment high, central bank officials are mulling new policy tools. Minutes from their last meeting, on July 31-Aug 1, show that "a couple" policymakers favored lowering the IOER, while "several others" raised concerns over possible harm to money markets.

Fed officials fear a crash in money markets -- whose guaranteed-return model is already challenged by extremely low interest rates -- could spread to other parts of the financial system, and they see the funds as a key potential source of contagion from Europe's financial crisis.

Some Wall Street economists had anticipated the Fed to lower the IOER at the August 1 meeting. But the Fed ultimately stood pat, saying only that it was prepared to act to help the economic recovery if need be.

The next meeting is set for September 12-13, though all ears will be on Bernanke's much anticipated speech in Jackson Hole, Wyoming on Friday for clues on policy.

Meanwhile, U.S. policymakers are looking to their European counterparts as they consider lowering IOER.

The European Central Bank recently lowered to zero, from 0.25 percent, its equivalent rate, while Denmark's central bank went so far as to charge banks 0.20 percent on certain deposits - effectively paying a negative interest rate.

The New York Fed paper showed that, since 2008, the funds that U.S. banks held on deposit at the Fed have spiked from near zero to some $1.6 trillion, the vast majority of which are excess reserves.

The spike had the effect of increasing the Fed's total liabilities while, over the same period, the Fed's large-scale asset purchases boosted its assets. Together this increased the overall money supply in the economy, or "monetary base."

Because lowering the IOER would not change the quantity of assets held by the Fed, the economists concluded, "it must not change the total size of the monetary base either."

(Reporting by Jonathan Spicer; Editing by W Simon)

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