Federal Reserve officials are renewing a debate over cutting interest paid to banks on excess reserves, a move aimed at convincing investors that tapering its bond-buying isn’t the same as tightening its monetary policy.
Lowering the rate, now 0.25%, is among “ideas that are still in play” as the central bank seeks to improve the way it communicates the outlook for interest rates, Atlanta Fed President Dennis Lockhart said on Dec. 5.
The debate was revived as the Fed successfully tests a new policy involving so-called reverse repurchase transactions that would give it greater control over short-term borrowing costs. That may ease concern that cutting the interest rate on excess reserves could wreak havoc by pushing rates to zero or lower in money markets. Holdings in money market mutual funds total about $2.7 trillion, according to research firm iMoneyNet in Westborough, Massachusetts.
The reverse repo tool “definitely has the potential to minimize some of the risks that were cited often over the past years” when officials discussed cutting interest on excess reserves, said Dana Saporta, director in U.S. economics research at Credit Suisse Group AG in New York. “This opens up a potential cut and helps to reduce some of those concerns.”
Fed officials, who next meet Dec. 17-18, have been debating when to start winding down the $85 billion in monthly bond purchases that have pushed the balance sheet to a record $3.93 trillion.
One concern: how to start tapering without also pushing up borrowing costs. Officials sent 10-year Treasury yields more than a percentage point higher from May to September by making comments that fueled taper expectations. Cutting IOER could be used as a signal that policy will remain easy, according to minutes of the October Federal Open Market Committee meeting.
“Most participants thought that a reduction by the Board of Governors in the interest rate paid on excess reserves could be worth considering at some stage,” the minutes showed.
Mohamed El-Erian, chief executive officer of Pacific Investment Management Co., is among those who say the Fed is likely to couple a tapering announcement with a reduction in interest on reserves.
“You’re looking at a transition where the Fed will remain engaged but will alter its policy mix,” by gradually reducing its bond buying while strengthening its forward guidance on keeping short-term interest rates low, El-Erian said in an interview this week.