Fed seeks approval to pay interest on reserves
WASHINGTON (Reuters) - The U.S. Federal Reserve has decided to seek authority from Congress to begin paying interest on commercial bank reserves this year, a tool that could help it thaw frozen credit markets, a person familiar with the issue said on Wednesday.
Paying interest on the reserves banks are required to hold at the Fed to balance customers' deposits would make it easier for the central bank to move more funds into financial markets seized in the grip of a credit crunch without driving down benchmark interest rates.
The Fed has taken a number of emergency steps to restore normal flows of funds in credit markets reeling from a surge in mortgage delinquencies and the bursting of the U.S. housing bubble. The decision to ask Congress to let the Fed begin paying interest on reserves this year was first reported in the Wall Street Journal.
"It's particularly relevant now because the Fed would like to put a bunch of cash in the market, and it can do that beyond what the market will take at the given (benchmark interest) rate only by increasing the demand (for reserves)," said Douglas Elmendorf, a former Fed staffer now at the Brookings Institution. Paying interest should spark that demand.
Seeking authority to pay interest on reserves is the latest in a series of emergency actions the Fed has taken as it strives to ease credit market strains.
Last week, it said it would expand twice-monthly cash auctions to banks to $75 billion and bulk up currency swap lines with the European Central Bank and Swiss National Bank to ensure dollar funding is available in European markets.
It has also invoked powers not used since the Great Depression to offer emergency credit to Wall Street bond dealers.
In addition, the U.S. central bank has lowered its target for the federal funds rate -- the rate banks charge each other for overnight loans -- to 2 percent from 5.25 percent since mid-September to buffer the economy from the deep housing downturn and related credit crisis.
However, some Fed officials worry that the lower interest rates are inadvertently fueling inflation. Dallas Federal Reserve Bank President Richard Fisher, who has voted against the two most recent Fed rate reductions, has suggested the Fed focus on tools to provide liquidity instead of rate cuts.
BERNANKE'S FORMAL REQUEST EXPECTED SOON
Because the Fed cannot currently pay interest on reserves, banks try to hold as few reserves as possible at the central bank.
When the Fed sets a target interest rate, Fed staff have to gauge market demand for funding to hit that target. Even in normal market conditions, the relatively low level of demand for reserves complicates that task, Elmendorf said.
Paying interest on reserves would boost demand for reserves and could help the Fed pump liquidity into markets without lowering benchmark rates.
Already, with its range of efforts, the Fed has committed roughly half of the U.S. Treasury securities it holds on its approximately $800 billion balance sheet to provide liquid funds to markets. If it paid interest on reserves, it could expand its balance sheet without pushing interest rates down.
Central bank officials began talks on Capitol Hill on Monday about the idea of moving to pay interest on reserves this year, the source said. Fed Chairman Ben Bernanke is expected to ask for the new authority soon, the source confirmed. Continued...
