November 17, 2009 / 1:46 PM / 10 years ago

New tool in Fed shed to do heavy lifting in exit

WASHINGTON (Reuters) - The U.S. Federal Reserve may rely principally on the largely untested monetary policy tool of paying interest on bank reserves when the time eventually comes to raise borrowing costs.

The U.S. central bank’s traditional approach of aiming for a federal funds rate target rate by buying and selling Treasury securities in the open market could be relegated to a supporting role in the initial stages of a tightening.

“In the old days ... the Fed controlled the federal funds rate with open market operations,” said Antulio Bomfim, a former Fed economist now with Macroeconomic Advisors in Washington.

“Now, at least in this period when reserves are over-abundant, the way the Fed hopes to raise the federal funds rate will be primarily by raising the interest rate it pays on reserves,” he said.

The Fed cut its target for the overnight rate to near zero in December and has flooded the banking system with money in an effort to stem a financial crisis and deep recession, more than doubling its balance sheet in the process.

Some economists, including some policymakers at the Fed, are worried the extraordinary liquidity the central bank has provided could end up sparking inflation.

While the central bank has pledged to keep borrowing costs ultra low for an extended period to nurture the fragile recovery, officials have begun to consider how best to eventually remove that extraordinary economic support.

‘POLICY RATE’ BAND

Making interest on reserves its leading policy tool would mark yet another unexpected twist in the Fed’s response to the financial meltdown.

When the Fed pays interest on reserves, it can persuade banks to keep their money at the central bank when returns in private markets are lower.

In so doing, it can maintain a floor under the fed funds target — the rate banks charge each other for overnight loans and normally the Fed’s main tool for influencing the economy.

With interest on reserves, investors looking to the central bank for cues on monetary policy might find themselves thinking about a “policy rate” band between the rate paid on reserves and the fed funds target.

This would make the Fed more like other central banks around the world that have “corridors” for their policy rate, with interest on reserves setting the lower bound.

To enhance its control over borrowing costs, the Fed is also likely to conduct a series of open market operations to drain reserves from the banking system, possibly at the same time it raises interest rates.

Such tools include reverse repurchase agreements in which the Fed will sell Treasury securities for a short period, or term deposits, similar to the certificates of deposit consumers use to park money at banks.

POWERFUL TOOL

There is also a lively debate about whether the Fed should extinguish the reserves or permanently maintain a larger balance sheet, according to Marvin Goodfriend, a former director of research at the Richmond Fed who now teaches at Carnegie Mellon University in Pittsburgh.

“There is a question of whether there should be a bigger central bank footprint on a permanent basis,” he said.

Congress gave the Fed the power to pay interest on reserves in October 2008 as part of emergency legislation to address the financial crisis, and officials believe it is a powerful tool.

San Francisco Federal Reserve Bank President Janet Yellen has said she thinks interest on reserves will be sufficient by itself to tighten financial conditions.

“The fact that they introduced interest on reserves tells you that they think that system gives them better control,” said Charles Lieberman, a former head of monetary policy analysis at the New York Fed now with Advisors Capital Management in Hasbrouck Heights, New Jersey.

Reporting by Mark Felsenthal, Editing by Chizu Nomiyama

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