Federal Reserve policymakers are considering adopting a new benchmark interest rate to replace the one they have used for the past two decades.
The central bank has been unable to control the federal funds rate since the September 2008 bankruptcy of Lehman Brothers Holdings Inc., when it began flooding financial markets with $1 trillion to prevent the economy from collapsing. Officials, who started a two-day meeting Tuesday, have said they may replace or supplement the fed funds rate with interest paid on excess bank reserves.
"One option you might want to consider is that our policy rate is the interest rate on excess reserves and we let the fed funds rate trade with some spread to that," Richmond Fed President Jeffrey Lacker told reporters this month in Linthicum, Md.
The central bank needs to have an effective policy rate in place when it starts to raise interest rates from record lows to keep inflation in check, said Marvin Goodfriend, a former Fed economist. Policymakers are concerned that the Fed funds rate, at which banks borrow from one another in the overnight market, may fail to meet the new target, damaging their credibility and their ability to control inflation as the economy recovers.
The choice of a benchmark is the "front line of defense against inflation, and also it's at the heart of the central bank being able to precisely and flexibly guide interest rate policy in the recovery," said Goodfriend, a professor at Carnegie Mellon University in Pittsburgh.
Fed Chairman Ben Bernanke, in July congressional testimony, called interest on reserves "perhaps the most important" tool for tightening credit.
Banks' excess reserves, or deposits held with the Fed above required amounts, totaled $1 trillion in the two weeks that ended Jan. 13, compared with $2.2 billion at the start of 2007. The Fed created the reserves through emergency loans and a $1.7 trillion purchase program of mortgage-backed securities, federal agency and Treasury debt.
By raising the deposit rate, now at 0.25%, officials reckon banks will keep money at the Fed and not stoke inflation by lending out too much as the economy recovers.
Without a federal funds target, banks might have to find a new way to set the prime borrowing rate, which is the figure most familiar to consumers and which is now pegged at 3 percentage points above the fed funds target.
In the past the Fed has controlled the rate by buying or selling Treasury securities, adding or withdrawing cash from the system. That mechanism broke down when the central bank started flooding the system with cash after the bankruptcy of Lehman Brothers to prevent a financial meltdown. The deposit rate would help set a floor under the fed funds rate, because the Fed would lock up funds by offering a fixed rate of interest for a defined period and prohibiting early withdrawals.
"In general, banks will not lend funds in the money market at an interest rate lower than the rate they can earn risk-free at the Federal Reserve," Bernanke said in an October speech in Washington.
There could be complications to using the deposit rate. Banks may be able to generate more revenue by lending at prime rate rather than by earning interest at the Fed, said William Ford, a former Atlanta Fed president at Middle Tennessee State University in Murfreesboro.
Also, the Fed's direct control over a policy rate — instead of targeting a market rate — could skew trading and financing toward short-term borrowing once investors know the rate won't change between Fed meetings, said Vincent Reinhart, a former Fed monetary-affairs director who is now a resident scholar at the American Enterprise Institute in Washington.