Federal Reserve officials are staking their inflation-fighting credibility on an untested tool: the power to pay interest on bank reserves.

Congress granted the Fed this ability in 2008, and Chairman Ben S. Bernanke, Vice Chairman Janet Yellen and New York Fed President William Dudley have all cited it as a main reason why they’ll be able to keep the U.S. economy from overheating after pumping record amounts of cash into the financial system. Raising the rate, currently at 0.25 percent, is intended to entice banks to keep their money on deposit at the Fed instead of loaning it out and stoking inflation.

With the benchmark overnight lending rate trading at 0.1 percent, less than half the deposit rate, it isn’t clear how much control the central bank can exert over borrowing costs by raising the interest on reserves, said Dean Maki, chief U.S. economist at Barclays Capital. Internal critics also have cast doubt on the tool’s effectiveness. Philadelphia Fed President Charles Plosser said last month it isn’t a cure-all because it doesn’t address the need to shrink the central bank’s balance sheet and reduce the amount of reserves in the system.

“There is some concern in markets about whether the Fed will keep inflation under wraps as it goes through this exit strategy,” Maki said in a telephone interview from his New York office. “It’s unknown exactly what interest on reserves does to the economy.”

Cash in the banking system has ballooned since the credit crisis began in 2007, when the Fed embarked on its unprecedented monetary accommodation, which includes two bond-purchase programs that have swelled the central bank’s balance sheet to a record $2.69 trillion.

Excess Reserves

The amount of excess reserves climbed to $1.47 trillion this month from $991 billion at year-end and $2.2 billion at the start of 2007, Fed data show.

The Federal Open Market Committee began a two-day meeting Tuesday and will decide whether to continue with its planned $600 billion of bond purchases through June.

The effectiveness of using interest on reserves, or IOR, as a main policy tool may depend on how closely the federal funds rate, or overnight inter-bank lending rate, follows its movements. The Fed has kept its target for the fed funds rate at zero to 0.25 percent since December 2008.

“The big unknown is how tight the spread between the IOR and effective fed funds rate will be,” said Dino Kos, a managing director at economic-research firm Hamiltonian Associates Ltd. in New York. “If the fed funds rate trades at a stable, and preferably narrow, discount to the IOR, then tightening policy through the IOR is doable. But a wide and unstable spread undermines the strategy.”

Withdrawing Cash

Kos is a former executive vice president and markets-group head at the New York Fed. The central bank has historically moved the federal funds rate by buying or selling Treasury securities, adding or withdrawing cash from the system.

The Fed probably would like to mimic the so-called corridor system in Europe, where the deposit rate acts as a floor to the overnight lending rate, according to Stephen Stanley, chief economist at Pierpont Securities LLC in Stamford, Connecticut. The U.K. central bank’s benchmark, now at 0.5 percent, is the rate it pays on the reserves it holds for commercial banks. That’s below the overnight sterling London interbank offered rate of 0.57 percent.

The Frankfurt-based European Central Bank pays a rate on the deposits banks park with it overnight. The ECB raised this rate a quarter point to 0.5 percent on April 7, the same day it increased its benchmark refinancing rate by the same margin to 1.25 percent.

Reverse Repurchase Agreements

Before the Fed boosts the deposit rate, it likely will use reverse repurchase agreements and its new Term-Deposit Facility to gain more control over the federal funds rate, Stanley said. He predicts the Fed will raise rates as soon as November, which he said is an “aggressive” time frame that reflects his concern inflation will accelerate.

In a reverse repo, the Fed lends securities for a set period, draining bank reserves from the financial system. At maturity, the securities are returned to the Fed, and the cash goes back to the primary dealers.

Stanley said he’s skeptical these transactions can operate at a scale big enough to suck sufficient cash from the system to control the federal funds rate. The rate fell as low as 0.08 percent on April 13 after the Federal Deposit Insurance Corp. began adjusting calculations of U.S. banks’ deposit-insurance fees this month to cover all liabilities instead of just domestic deposits.

‘Significant Sellers’

The overnight lending rate has traded below the interest rate on reserves for almost two years, partly because Fannie Mae and Freddie Mac, the mortgage-finance companies under government control, became “significant sellers” of funds in the overnight market and aren’t eligible to place cash on deposit at the Fed, according to a December 2009 research paper by the New York regional reserve bank.

The “theory” of interest on reserves is “proved wrong every day: Why would a bank ever lend at less than what they’re earning at the Fed?” Maki said. “There are more issues here than it sometimes is made to sound. Chairman Bernanke mentioned the Fed could raise rates in 15 minutes if they decided to, but it’s not clear they have that kind of control on the funds rate.”

While Stanley says Bernanke, Dudley and Yellen’s premise -- that raising interest on reserves should dissuade banks from extending credit -- is valid, policy makers may have to increase rates faster than they’d like because a 25 basis-point jump in the deposit rate won’t deter a bank from making a loan on which it would earn 6 percent interest, Stanley said.

‘Academic Question’

“I will grant the point that Bernanke and others at the Fed have made over and over again, that ‘We have the tools,’ but really what they’re getting at is, in some ways, an academic question,” Stanley said. “The problem is in thinking through the implications.”

Bernanke called interest on reserves “perhaps the most important” tool for tightening credit in July 2009 congressional testimony, and he and his top lieutenants have expressed confidence in the deposit rate’s ability to quash inflation.

Dudley, who is also vice chairman of the FOMC, said in response to audience questions after a Feb. 28 speech that he is “absolutely convinced” raising interest on reserves will prevent a rapid acceleration in prices.

“It’s very important that we at the Fed can convince people that this new tool is a viable means of preventing the economy from overheating,” Dudley said. “People should be very, very comfortable that we’re not going to let inflation get out of hand.”

Harsh Political Backlash

Yellen also emphasized the deposit rate in a Jan. 8 speech defending the central bank’s second round of asset purchases. The Nov. 3 decision to embark on the $600 billion program sparked the harshest political backlash against the Fed in three decades, with Republican lawmakers saying the policy risked causing a surge in inflation.

“I disagree with the notion that the large quantity of reserves resulting from our asset purchases poses some special barrier to removing policy stimulus when the right time comes,” Yellen said. The ability to raise the deposit rate “will allow us to manage short-term interest rates effectively and thus to tighten policy when needed, even if bank reserves remain high.”

Michael Feroli, chief U.S. economist at JPMorgan Chase & Co., said he expects interest on excess reserves to be the Fed’s new benchmark rate, and it will be “effective enough.”

Mortgage Holdings

“Maybe you won’t be able to precisely get the funds rate to where you want it to be every day, but I think when” the deposit rate “goes up, interest rates in general will go up,” said Feroli, who predicts the Fed will stop reinvesting interest payments from its mortgage holdings in the second half of this year and won’t raise the deposit rate until 2013.

Feroli said he’s confident the Fed will be able to control inflation as the economy improves.

“If anything, they’ve got more ways to whack the economy now than they did before,” he said. “If you really do have an inflation problem, not only can you raise overnight rates, you can sell a trillion dollars in mortgages or Treasurys.”

While Bernanke, Dudley and Yellen have advocated interest on excess reserves to stop inflation, other members of the FOMC have proposed taking different approaches to withdraw stimulus. St. Louis Fed President James Bullard said March 30 that a “logical” order for an exit plan would be for the Fed to sell assets before raising rates. Dallas Fed President Richard Fisher said Feb. 15 that he may prefer selling Treasurys as a first step.

‘Policy Instrument’

Plosser said March 25 that the federal funds rate should be the main policy instrument, not the deposit rate, because it’s more “familiar” to the market and central bankers. He outlined a strategy for the exit, saying the Fed should set a pace for selling its mortgage and Treasury holdings in conjunction with boosting rates.

“The center of the committee is looking for asset sales after the rate increase” and is likely to get its way, even though the so-called hawks like Plosser and Fisher can “certainly make a lot of noise,” Feroli said.