Yellen Sees Chance Fed Could Cut Rate It Pays Banks on Reserves

Federal Reserve Vice Chairman Janet Yellen left open the possibility that the central bank could reduce the interest rate it pays on bank reserves as a way of aiding the economy.

“It is something we could consider going forward,” Yellen told the Senate Banking Committee yesterday in a hearing on her nomination to succeed Ben S. Bernanke as Fed chairman. “It certainly is a possibility.”

A cut in the 0.25 percent rate would help reinforce the Fed’s message that it intends to keep monetary policy easy even as it starts to reduce its asset purchases, said Carl Lantz, head of interest-rate strategy in New York at Credit Suisse Group AG. A coupling of the moves -- which could come in the first quarter of 2014 -- would help contain upward pressure on bond yields resulting from a pullback in quantitative easing, he said.

“The Fed could sugarcoat tapering by cutting” the rate it pays on excess reserves, Lantz said. Excess reserves are money that banks hold at the Fed above that required to cover some of their liabilities.

The central bank’s policy-making Federal Open Market Committee has considered lowering the rate at various points, only to decide against it out of concern that it could damage the money markets by pushing rates to zero or lower and drying up trading. Yellen made that point again yesterday.

A reduction “is something that the FOMC has discussed and the board has considered on past occasions,” Yellen told the lawmakers. “We’ve worried that if we were to lower that rate to close to zero, we would begin to impair money-market function.”

Rate Floor

The Fed’s introduction in September of a new tool for managing money-market rates probably mitigates some of that concern, said Kenneth Silliman, head of U.S. short-term rates trading at Toronto-Dominion Bank’s TD Securities unit in New York. The tool would help the Fed put a floor under money-market rates, even if it cuts the rate on reserves.

The new instrument allows banks, broker-dealers, money-market funds and some government-sponsored enterprises to lend the Fed cash overnight at a fixed rate in exchange for borrowing Treasuries in so-called reverse repurchase transactions. The tool -- called the fixed-rate, full-allotment overnight reverse repo facility -- began at a rate of 0.01 percent. It has since been increased to 0.04 percent.

Federal Reserve Bank of Minneapolis President Narayana Kocherlakota backed a cut in the rate the central bank pays on excess reserves in a speech on Nov. 12. Such a step would provide “more monetary stimulus to the economy,” he told business leaders in St. Paul, Minnesota.

Encouraging Lending

Former Fed Vice Chairman Alan Blinder has been a vocal advocate of cutting the rate on reserves to zero as a way to encourage banks to lend money to households and companies rather than keeping it at the central bank. Now a professor at Princeton University in New Jersey, Blinder welcomed yesterday’s remarks by Yellen.

“It was far from a ringing endorsement, but the next chair of the Fed at least left the door open -- a crack,” he said in an e-mail. “She’s both smart and open-minded. Maybe this idea will get a rethink at the Fed. I certainly hope so.”

Banks’ reserves have mushroomed as the Fed purchased securities from them in its bid to lower long-term interest rates. Banks currently have more than $2 trillion in extra cash at the Fed, according to data from the central bank.

Bond Purchases

The Fed is buying $85 billion worth of bonds per month and has said it will hold short-term rates near zero at least as long as unemployment is above 6.5 percent and the forecast for inflation is below 2.5 percent. The jobless rate in October was 7.3 percent, while inflation in September was at a year-over-year rate of 0.9 percent.

Some economists voiced doubts that the Fed will reduce the rate it pays on reserves. It won’t “come back into play as an option for Fed policy,” Michael Feroli, a former Fed researcher who is now chief U.S. economist for JPMorgan Chase & Co. in New York, said in an e-mail to clients yesterday.

Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York, said such a move would do little to promote a faster recovery of the economy because the rate is already so low.

Silliman said, though, that a cut would help narrow the spread between money-market rates and what the Fed pays banks on reserves. The effective rate on federal funds traded between banks was 0.08 percent on Nov. 13.

In a Nov. 8 report to clients, Lantz estimated that the Fed has paid “excess interest” of $5.1 billion to the banking system since December 2008 as a result of the spread between the rates in the market and what it’s been paying out.

“With a move to new Fed chairperson, there’s scope to bring back on the table” a reserve-rate cut, he said in an interview.

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