Why Major Change in Fed's Interest Rate Policy Would Be Worrisome

Prior to the Federal Open Market Committee meeting in January, there was speculation about whether the Fed's monetary-policy arm would announce a shift in the benchmark rate away from the overnight rate it charges banks, to the interest paid on bank reserves. Economists at Bank of America (BAC) joined the speculation that the Fed may start pointing to the rate paid on reserves as its primary monetary-policy tool. While this might seem like inside-baseball for most Americans, the change could result in higher interest rates for your business or consumers loans and especially most credit cards that are now variable and reset based on the ups and downs of the prime rate.Finance Professor Jeff Rosensweig, who teaches at Emory's Goizueta Business School and is a former Federal Reserve senior economist, said when the Fed currently wants to target interest rates, it uses the federal funds rate, which is the overnight rate that it charges banks. This is the only interest rate the Fed can directly and fully control. That is unlike, for example, bond interest rates, which are determined by the market. "In recent years, the prime rate charged by banks is spread, such as 3%, over the federal funds rates," he says.

A Possible Chain Reaction

Rosensweig says that most credit-card rates are variable and determined by the prime rate plus a percentage. That percentage is often quite a large premium over prime, he says. If the Fed shifted to control bank reserves, this could "lead to a chain reaction: Fed funds rate up, prime rate up, and consumers pay even higher interest rates on their credit cards," Rosensweig said. "Not a pretty picture in a moribund economy."

Rosensweig thinks that inflation is not an issue, now, when we have double-digit unemployment. "It might be in a few years, but now we must keep the nascent recovery going," he said. "That means targeting interest rates as low as possible."

If the Fed does shift its benchmark to the interest rate on reserves, it won't be the first time a tool to control money supply was used. Rosensweig pointed to economists termed "monetarists," led by the late Milton Friedman, who "argued that the Fed should target the money supply instead, for example, by controlling the level of bank reserves."

Inflation Or Unemployment?

This was tried after Paul Volcker became Fed Chairman in 1979. The goal was to cure inflation, and it did, but at the cost of our last episode of double-digit unemployment.

Paying interest on reserves is a relatively new tool and was not available at the time Volcker was chairman. But it would still be a tool to control the money supply. It was first implemented in October 2008. Originally, the Federal Reserve was authorized to begin paying interest on balances held by or on behalf of depository institutions beginning Oct. 1, 2011.

But that date was moved up to October 2008 as part of the Emergency Economic Stabilization Act of 2008. The Fed pays interest, currently at the rate of 0.25% on both required reserves and excess reserves.

Unwinding The Stimulus

Both Federal Reserve Chairman Ben Bernanke and Jeffrey Lacker, President of the Federal Reserve Bank of Richmond, have signaled that the Fed does intend to use this new money supply tool to unwind the stimulus. But neither indicated that it would mean a change in the benchmark rate or that the tool would begin to be used any time soon.

In a speech on Oct. 8, 2009 as part of the Federal Reserve Board Conference on Key Developments in Monetary Policy in Washington, D.C., Bernanke indicated that while economic conditions were not right for unwinding the stimulus, the "ability to pay interest on reserves should be sufficient to allow the Federal Reserve to raise interest rates and control money growth."

But he also said "this approach is likely to be more effective in combination with steps to reduce excess reserves." He then went on to explain the three steps the Fed would use:
  • Large-scale reverse purchase agreements (reverse repos), which involve the sale by the Federal Reserve of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later data. These reverse repos drain available cash as purchasers transfer cash from the bank to the Fed.
  • Offer term deposits to banks, similar in concept to a Certificate of Deposit offered bank customers, that would not be available to be supplied to the federal funds market.
  • Reduce reserves by selling a portion of its holdings of long-term securities in the open market
"Each of these policy options would help to raise short-term interest rates and limit the growth of broad measures of money and credit, thereby tightening monetary policy," Bernanke explained in his speech. Bernanke added that the Fed has a wide range of tools for tightening monetary policy when necessary. "We will calibrate the time and pace of any future tightening, together with the mix of tools, to best foster our dual objectives of maximum employment and price stability."

Another Weapon In The Arsenal

Lacker also sees this new tool of interest on bank reserves as just another in the arsenal available for unwinding the stimulus. He said in speech before the Maryland Bankers Association on Jan. 8, 2010 that during the recovery period there will be a risk of inflation edging upward, which has occurred during some past recoveries. He believes the risk appears to be minimal right now. But, he said, "we will have to be careful as the recovery unfolds to keep inflation and inflation expectations from drifting around."

He added that when and how to withdraw the considerable monetary policy stimulus now in place must be done carefully during every recovery. Now with the tool of interest on bank reserves, "the Fed will have two monetary policy instruments at its disposal, not just one."

Traditionally the Fed targeted the overnight federal funds rate to adjust the supply of money. This rate affects a broad range of other market interest rates, influencing growth and inflation, Lacker said. Since October 2008, he said the Fed has the authority to pay explicit interest on the reserve balances banks hold.

Targeting An Interest Rate Range

This gives the Fed the ability to vary the amount of our money held by banks, as well as the federal funds rate. "So when the time comes to withdraw monetary stimulus, the [the Fed's rate-setting arm] will be able to raise the interest rate on reserves or drain reserve balances, or both," he said.

So while there is no question that interest on reserves is being seen as a tool for unwinding the stimulus, it's not as clear that the Fed plans to actually change the benchmark to interest on reserves. But many economists do expect that the Fed will continue to target a range, such as it is now of 0% to 0.25% rather then set a specific rate for the federal funds rate.

When the Fed starts using the new tool of interest on reserves and starts raising that interest rate above its current 0.25%, banks will be less likely to want to lend unless they can get more than the Fed is promising to pay without risk. That will start a chain reaction, as Rosensweig pointed out, which will mean the Fed funds rate will go up, then the prime rate will go up and finally the rate consumers will pay will go even higher.


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