Tags: Fed | Interest | Reserves

Another Way the Fed Might Boost Recovery

Wednesday, 27 Oct 2010 08:13 AM

Wall Street is hotly anticipating the start of another round of U.S. debt purchases by the Federal Reserve, but some investors are already looking past the likely Fed announcement, wondering whether to plan for other central bank options to boost the recovery.

While the Fed's second round of quantitative easing efforts will most likely begin with a Treasury purchase program, the idea that the Fed should reduce or eliminate the interest it pays on deposits held in reserve is enjoying a renaissance on parts of Wall Street.

The Fed began paying interest on excess reserves two years ago to try to control more tightly the real interest rate compared with its fed funds target rate. Banks with cash reserves at the Fed currently earn 25 basis points on those deposits.

"In our view, the cost-benefit analysis of a cut in the interest on excess reserves rate is becoming more favorable," wrote Jim Lee, head of futures strategy at RBS Securities in Stamford, Connecticut, in a note to clients.

"We would not be surprised to see the Fed opt to slash the rate in the coming months."

With short-term interest-rates at historic lows, the Fed's 25 basis-point interest rate looks like a comfortable spot, and banks are not motivated to do much with their cash beyond hoarding it at the central bank.

Some economists argue that if the Fed were to reduce or eliminate interest payments on reserves, banks would put their money to work in other ways, such as new loans or real assets. They say such moves would be a more effective way to stimulate economic growth — the ultimate goal of quantitative easing — than Treasury purchases.

"Academic economists tend to like it because they think this will somehow flush out the $1 trillion in excess reserves," said Lou Crandall, chief economist at Wrightson ICAP in New York.

But he said he did not think the move was likely in the current environment, in which the U.S. economic recovery looks sluggish but not entirely stalled.

"If we appear to be falling into a double dip, that would be one of the five things the Fed would do as part of the next 'kitchen sink' strategy," Crandall said.

Indeed, interest in the move seems to be stronger in New York than in Washington. During a recent spate of public appearances here, Fed officials fielded audience queries about the potential move, even though the last official mention of it came in a speech Fed Chairman Ben Bernanke gave at the Fed gathering in Jackson Hole, Wyoming, in August.

RBS' Lee said such a move would lead investors to take more risks on longer-dated Treasuries and credit instruments and suggested ways to trade on it.

"If it happens, we should see bull flattening of yield curve and compression of credit spreads," he wrote in his note on Monday. "We suggest a number of trades that would benefit should the interest on excess reserves rate be cut, or a limit be placed on the amount of excess reserves allowed."

Other investors say they have contemplated the scenario, though they have not acted on it.

"We thought about it," said Thanos Bardas, a portfolio manager at Neuberger Berman Fixed Income in Chicago, a firm with approximately $70 billion in fixed income assets under management.

Economists and strategists on Wall Street are almost certain that the Fed will announce another program to purchase Treasuries after its next Federal Open Market Committee Meeting ends on Nov. 3. But questions remain as to whether more Treasury purchases will have the desired effect, since Treasury yields are so low already.

In response to questions on the topic during their appearances last week, Dallas Fed President Richard Fisher and Fed Governor Elizabeth Duke each acknowledged that cutting the interest rate on reserves was a tool the Fed could potentially use. But they did not give any indication that it was being seriously discussed as a policy move.

Philadelphia Fed President Charles Plosser said Friday that the move could disrupt short-term funding markets.

Money-market funds, already searching for high-quality places to put investors' cash, would be hurt, investors argue, if interest rates fell any lower than they are now. The potential damage to money market funds is one of the biggest reasons why the Fed might try to avoid cutting the interest rate on excess reserves.

"If you do quantitative easing that is further out on the curve and it's steeper, you can get more benefits in terms of lowering the private sector borrowing costs," Bardas added.

© 2017 Thomson/Reuters. All rights reserved.

 
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Wall Street is hotly anticipating the start of another round of U.S. debt purchases by the Federal Reserve, but some investors are already looking past the likely Fed announcement, wondering whether to plan for other central bank options to boost the recovery. While the...
Fed,Interest,Reserves
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2010-13-27
Wednesday, 27 Oct 2010 08:13 AM
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