Federal Reserve Chairman Ben S. Bernanke may be taking anotherlook at cutting the interest rate the Fed pays on bank reserves tobring down short-term borrowing costs and spur the slowing U.S.expansion.

Bernanke testified to Congress on July 17 that reducing the ratefrom its current 0.25 percent is one of several easing steps theFed might take to reduce unemployment stuck above 8 percent formore than three years. In February, by contrast, the Fed chairmantold Congress that lowering the rate might drive away investorsfrom short-term money markets.

“They're reconsidering it,” said Ward McCarthy, a formerRichmond Fed economist. A July 5 decision by the European CentralBank to cut its deposit rate to zero is prompting renewed interestin the strategy, said McCarthy, chief financial economist atJefferies & Co. McCarthy said it's unlikely the Fed will reducethe rate at a two-day meeting that starts tomorrow.

Policy makers meeting this week are looking for new monetarytools after the Fed lowered its benchmark interest rate to nearzero in December 2008 and purchased $2.3 trillion of securities tospur the economy. A government report on July 27 showed economicgrowth slowed to a 1.5 percent annual rate in the second quarter asconsumers curbed spending.

“They are at the end of their rope and are probably searchingfor every last option for what they can do,” said Michael Feroli,chief U.S. economist at JPMorgan Chase & Co. in New York and aformer economist for the Fed Board in Washington. “You can't ruleanything out because they're going to flail around and try everylast thing they can.”

Feroli said the Fed may extend its time frame for keepinginterest rates low beyond late 2014 at the coming meeting. Anotheroption mentioned by Bernanke is a new round of large- scale bondpurchases, which McCarthy said is more likely to occur later thisyear than in August.

Central banks around the world are digging deeper into theirtool kits in search of innovative ways to unclog bank lending. TheFOMC meeting ends one day before ECB President Mario Draghi'sGoverning Council and Bank of England Governor Mervyn King'sMonetary Policy Committee.

The institutions' last meetings ended with the Fed prolongingits Operation Twist program to extend the maturities of assets onits balance sheet, the ECB cutting its benchmark rate to a recordlow 0.75 percent and the BOE restarting bond buying.

By reducing the interest it pays on excess reserves, a centralbank gives financial institutions an incentive to shift their moneyinto lending that yields a higher return. The aim is to expand thesupply of credit and speed economic growth.

Excess Reserves

Excess reserves have mushroomed as the Fed bought securitiesfrom banks in its bid to lower long-term interest rates. The amountof such reserves at the Fed was $1.49 trillion on July 25, up from$991 billion at the end of 2010 and $2.4 billion at the end of2007, Fed data show.

Traders have speculated the Fed will follow the ECB, pushingshort-term rates lower in the U.S., according to Jim Lee, head ofU.S. derivative strategy at Royal Bank of Scotland Group Plc's RBSSecurities Inc. in Stamford, Connecticut. The fed funds effectiverate fell to 14 basis points on July 27 from 17 basis points onJuly 5. A basis point is 0.01 percentage point.

“Part of the reason for the demand this month for short- termU.S. debt has been due to speculation that the Fed will cut theIOER following the ECB's move and given the lack of disruptions inEuropean money markets,” Lee said in an interview, referring to theinterest rate on excess reserves.

The yield on the two-year Treasury note was 0.24 percent on July27, down from 0.29 percent on July 5, while the implied yield foreurodollar futures that expire in December has fallen about 10basis points during the period. The rate is based on expectationsfor three-month dollar Libor, or the London interbank offeredrate.

“Clearly the market is purchasing some lottery tickets in casethe Fed does cut the IOER,” Lee said. The Fed has held the rate at25 basis points since December 2008.

After the ECB's cut, deposits at the central bank fell to 321billion euros ($396 billion) on July 26, the least since Dec.21.

The ECB's move fueled investor demand for short-term sovereigndebt from the region's safest nations, including Germany, Austria,and Finland, driving rates lower, with some of them falling belowzero for the first time. Investors holding debt with a negativeyield to maturity will receive less than they paid to buy thesecurities.

The central bank's action hasn't caused significant disruptionsin European markets, said Alex Roever, head of short-termfixed-income strategy at JPMorgan in New York.

Market Stability

Market stability following the ECB's move has probably promptedBernanke to reconsider, Feroli said. Rising short-term borrowingcosts may have also made the tool more appealing.

The fed funds effective rate — at 14 basis points on July 27 —has increased from six basis points at the end of September. Thatmonth the Fed announced its Operation Twist plan extending theaverage maturity of bonds in its portfolio by selling short-termsecurities and buying longer-term debt.

Also, the average rate for borrowing and lending Treasuries forone day through repurchase agreements, or repos, rose to as highthis year as 0.297 percent on July 2, from minus 0.001 percent atthe end of last year, a Depository Trust & Clearing Corp. indexof General Collateral Finance repos shows. The rate was 0.172percent on July 27. Securities dealers use repos to financeholdings and increase leverage.

If Bernanke decided to lower the deposit rate, he would probablyreduce it by about 10 or 12 basis points, instead of to zero,Feroli said.

A reduction may pose fewer political disadvantages thanBernanke's other stimulus options, including an expansion of theFed's balance sheet. The central bank's purchase of $2.3 trillionin securities during two rounds of so-called quantitative easinghas drawn fire from lawmakers, including House Speaker JohnBoehner, an Ohio Republican, concerned about inflation risks.

In contrast, some lawmakers have urged Bernanke to stop payinginterest on reserves.

“What you're actually doing by this is sort of incentivizing thebanks” to “keep their excess reserves at the Fed,” RepresentativeScott Garrett, a Republican from New Jersey, said to Bernankeduring Feb. 29 congressional testimony by the central bank chief.“Isn't that sort of counter to what your policy should be?”

Bernanke said the benefits from a rate reduction would be“pretty small.” Also, a cut would risk triggering some “financialside effects.”

Other Tools

The Fed's other stimulus tools include altering the language onthe outlook for interest rates and using the so-called discountwindow for direct lending to banks, Bernanke said in July 17congressional testimony.

“That's a range of things that we could do,” Bernanke said.“Each one of them has costs and benefits, and that's an importantpart of the calculation.”

An IOER reduction alone probably wouldn't buoy economic growth,said George Goncalves, head of interest-rate strategy in New Yorkat Nomura Holdings Inc., a primary dealer.

The Fed may make the cut “in combination with a change incommunication policy” extending the Fed's commitment to hold themain interest rate close to zero beyond late 2014, or paired withanother round of quantitative easing, Goncalves said.

Bloomberg News

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