Federal Reserve officials are renewing a debate over cutting interest paid to banks on excess reserves, a move aimed at convincing investors that tapering its bond-buying isn’t the same as tightening its monetary policy.
Lowering the rate, now 0.25 percent, is among “ideas that are still in play” as the central bank seeks to improve the way it communicates the outlook for interest rates, Atlanta Fed President Dennis Lockhart said on Dec. 5.
The debate was revived as the Fed successfully tests a new policy involving so-called reverse repurchase transactions that would give it greater control over short-term borrowing costs. That may ease concern that cutting the interest rate on excess reserves could wreak havoc by pushing rates to zero or lower in money markets. Holdings in money market mutual funds total about $2.7 trillion, according to research firm iMoneyNet in Westborough, Massachusetts.
The reverse repo tool “definitely has the potential to minimize some of the risks that were cited often over the past years” when officials discussed cutting interest on excess reserves, said Dana Saporta, director in U.S. economics research at Credit Suisse Group AG in New York. “This opens up a potential cut and helps to reduce some of those concerns.”
Fed officials, who next meet Dec. 17-18, have been debating when to start winding down the $85 billion in monthly bond purchases that have pushed the balance sheet to a record $3.93 trillion.
One concern: how to start tapering without also pushing up borrowing costs. Officials sent 10-year Treasury yields more than a percentage point higher from May to September by making comments that fueled taper expectations. Cutting IOER could be used as a signal that policy will remain easy, according to minutes of the October Federal Open Market Committee meeting.
“Most participants thought that a reduction by the Board of Governors in the interest rate paid on excess reserves could be worth considering at some stage,” the minutes showed.
Mohamed El-Erian, chief executive officer of Pacific Investment Management Co., is among those who say the Fed is likely to couple a tapering announcement with a reduction in interest on reserves.
“You’re looking at a transition where the Fed will remain engaged but will alter its policy mix,” by gradually reducing its bond buying while strengthening its forward guidance on keeping short-term interest rates low, El-Erian said in an interview this week.
The new reverse repo program was originally intended to help officials tighten policy by improving their control over short-term borrowing costs. Fed staff members gave a presentation on the possibility of the tool at the FOMC’s meeting in July, and the Federal Reserve Bank of New York began testing the operation in September.
The Fed in 2008 gained the authority to pay interest on banks’ excess reserves as a way to regulate the supply of credit to the economy. By raising the rate, the Fed could encourage banks to keep excess funds parked at the central bank. Lowering it would urge them to lend to customers.
Excess reserves have mushroomed as the Fed purchased securities from banks in its bid to spur growth by lowering long-term interest rates. Banks had about $2.4 trillion in extra cash at the Fed as of Nov. 27, according to data from the central bank.
Yet IOER has limited effectiveness in precisely controlling short-term rates because only banks are allowed to keep money on deposit at the central bank. Other financial firms that borrow and lend in the interbank money markets, such as mortgage-finance companies Fannie Mae and Freddie Mac, aren’t eligible.
The federal funds effective rate was 0.09 percent yesterday and has traded below IOER for four years. The rate, the average for overnight loans among banks, is the Fed’s benchmark.
The new tool, called the fixed-rate, full-allotment overnight reverse repurchase facility, is intended to put a floor under short-term money-market rates, which could prevent them from falling below zero if the Fed were to cut IOER. It allows banks, broker-dealers, money-market funds and some government-sponsored enterprises to lend the Fed unlimited amounts of cash overnight at a fixed rate, currently 0.05 percent, in exchange for borrowing Treasuries in reverse repo transactions.
In a reverse repo, the Fed lends securities for a set period, temporarily draining cash from the banking system. At maturity, the securities are returned to the Fed, and the cash to its counterparties.
The Fed’s tests since September have been going well, according to Simon Potter, head of the New York Fed’s markets group, which implements the central bank’s monetary policy.
“Market participants generally characterize the exercise as smooth, with minimal disruptions,” Potter said in a Dec. 2 speech. “Money-market experts have noted the exercise’s importance in the current environment of promoting market functioning; for example, it reduces the likelihood of pervasive, negative short-term rates trading.”
An average of $6.6 billion a day has been used under the program since Sept. 23. The repo tool has helped lift the rate for borrowing and lending Treasuries for one day to an average of 0.066 percent as of Dec. 10, from 0.051 percent the day the program was announced Sept. 20, according to a Deposit Trust & Clearing Corp. General Collateral Finance Treasury Repo Index.
In considering reducing IOER, Fed policy makers are revisiting a proposal they have rejected for the past five years, even as it was recommended by economists including former Fed Vice Chairman Alan Blinder.
Blinder argued that reducing IOER would encourage banks to lend out more of the money they now keep locked up at the Fed. That would spur growth and employment as companies use cheap money to hire and invest, he argued. Fed officials disagreed, concluding that such a move wouldn’t provide a powerful boost to the economy.
“The benefits of such a step were generally seen as likely to be small except possibly as a signal of policy intentions,” according to minutes of the FOMC’s October meeting.
The Fed has been forced to turn to unconventional easing strategies after lowering its benchmark rate to zero in December 2008. It has relied on asset purchases and communications tying expectations on the outlook for interest rates to everything from the unemployment rate to calendar dates.
“They’re grasping at straws for how to signal their plans for the fed funds rate, and lowering IOER could be part of that,” said Sam Coffin, an economist in New York at UBS Securities, one of the 21 primary dealers that trades directly with the Fed.
Michael Feroli, the chief U.S. economist at JPMorgan Chase & Co., said “I’m not sure what signal” lowering IOER would send, because the benchmark federal funds rate would remain little changed.
Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey, said reducing the IOER would make Fed communications “extremely complicated” because central bankers would be wielding the repo facility -- introduced as an aid for the eventual tightening of policy -- to add stimulus.
“From an operational standpoint it alleviates some concerns that you would have really negative outcomes,” said Thomas Simons, a money-market economist at Jefferies LLC in New York, another primary dealer. “But it’s a pretty esoteric thing, very convoluted.”
“It is something we could consider going forward,” Yellen, the current vice chairman, told the Senate Banking Committee on Nov. 14.
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