The U.S. Federal Reserve may take an unorthodox approach to raising interest rates by paying interest on bank reserves rather than relying on traditional open market remedies, as it exits from its long-term fiscal stimulus programs, Reuters reported today (Tuesday).

Paying interest on reserves is mostly untested and would represent an unexpected twist in the Fed's response to the financial meltdown.

"In the old days … the Fed controlled the federal funds rate with open market operations," Antulio Bomfim, a former Fed economist now with Macroeconomic Advisors LLC in Washington told Reuters. "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."

Usually, when the central bank wants to set a target for the federal funds rate it buys or sells Treasury securities on the open market, influencing interest rates by deploying or withdrawing capital.

By paying interest on reserves, the Fed makes it attractive for banks to keep their money at the central bank as long as interest rates in private markets are lower.

By doing that, the Fed can put a floor under the lending rate that banks charge each other for overnight loans, which is the central bank's traditional choice for influencing the economy. Open market operations to raise interest rates would be relegated to a supporting role in the initial stages of tightening.

In order to spark an economy mired in deep recession, the Fed flooded the financial system with liquidity in December by cutting its interest rate to near zero – a move that more than doubled its balance sheet.

More recently, the Fed has promised to keep rates “exceptionally low” for “an extended period,” to nurture the fragile recovery. Now, with some economists warning that extraordinary economic stimulus could spark inflation, officials have begun to consider how best to eventually remove the support.

In order to impose its will on borrowing costs, the Fed is likely also to use a combination of open market operations to drain reserves from the banking system, including reverse repurchase agreements. In those operations, the Fed sells Treasury securities for a short term, similar to the certificates of deposit consumers buy at banks.

The central bank got the power to pay interest on bank reserves in October 2008, when Congress passed emergency legislation to deal with the financial crisis.

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.

No Plan B

In another sign the Fed is wary of inflation, San Francisco Federal Reserve Bank President Janet Yellen said Tuesday that the central bank is keeping a close eye on the economy for signs of growth, acknowledging that record low interest rates and loose monetary policy cannot be maintained for too long.

"We all understand very well that we cannot have an accommodative policy for too long. That once these conditions no longer prevail, it is a core responsibility of the Federal Reserve to preserve price stability," she said after a speech in Hong Kong, according to Reuters.

Last week in a speech in Phoenix, Yellen questioned the strength and durability of the U.S. economy, which expanded in the third quarter for the first time in more than a year.

"Unemployment could stay high for several years to come,” said Yellen. “High unemployment, weak job growth and paltry wage increases are a recipe for sluggish consumer spending growth and a tepid recovery."

But Yellen, a voting member on the Fed's policy-setting body, said that there is already enough stimulus in the financial system to bring the economy back to growth and there are no plans for further credit easing.

"We are not going to push them (the emergency actions to increase liquidity in the banking system) further," she said. "There is no plan B."

Former Bank of England deputy governor John Gieve, who also sat on the panel in Hong Kong, added, "There was never a plan B, so it's good plan A worked."

News & Related Story Links:

• Reuters:
  New tool in Fed shed to do heavy lifting in exit
• Reuters:
  Fed's Yellen: Can't have easy money for too long
• MarketWatch:
  Fed's Yellen see signs of jobless recovery

Tags: Don Miller, Federal Reserve System, Fiscal Policy, Inflation, Interest Rates