Federal Reserve Chairman Ben S. Bernanke may be taking another look at cutting the interest rate the Fed pays on bank reserves to bring down short-term borrowing costs and spur the slowing U.S. expansion.

Bernanke testified to Congress on July 17 that reducing the rate from its current 0.25 percent is one of several easing steps the Fed might take to reduce unemployment stuck above 8 percent for more than three years. In February, by contrast, the Fed chairman told Congress that lowering the rate might drive away investors from short-term money markets.

“They’re reconsidering it,” said Ward McCarthy, a former Richmond Fed economist. A July 5 decision by the European Central Bank to cut its deposit rate to zero is prompting renewed interest in the strategy, said McCarthy, chief financial economist at Jefferies & Co. McCarthy said it’s unlikely the Fed will reduce the rate at a two-day meeting that starts tomorrow.

Policy makers meeting this week are looking for new monetary tools after the Fed lowered its benchmark interest rate to near zero in December 2008 and purchased $2.3 trillion of securities to spur the economy. A government report on July 27 showed economic growth slowed to a 1.5 percent annual rate in the second quarter as consumers curbed spending.

“They are at the end of their rope and are probably searching for every last option for what they can do,” said Michael Feroli, chief U.S. economist at JPMorgan Chase & Co. in New York and a former economist for the Fed Board in Washington. “You can’t rule anything out because they’re going to flail around and try every last thing they can.”

Time Frame

Feroli said the Fed may extend its time frame for keeping interest rates low beyond late 2014 at the coming meeting. Another option mentioned by Bernanke is a new round of large-scale bond purchases, which McCarthy said is more likely to occur later this year than in August.

Central banks around the world are digging deeper into their tool kits in search of innovative ways to unclog bank lending. The FOMC meeting ends one day before ECB President Mario Draghi’s Governing Council and Bank of England Governor Mervyn King’s Monetary Policy Committee.

The institutions’ last meetings ended with the Fed prolonging its Operation Twist program to extend the maturities of assets on its balance sheet, the ECB cutting its benchmark rate to a record low 0.75 percent and the BOE restarting bond buying.

By reducing the interest it pays on excess reserves, a central bank gives financial institutions an incentive to shift their money into lending that yields a higher return. The aim is to expand the supply of credit and speed economic growth.

Excess Reserves

Excess reserves have mushroomed as the Fed bought securities from banks in its bid to lower long-term interest rates. The amount of such reserves at the Fed was $1.49 trillion on July 25, up from $991 billion at the end of 2010 and $2.4 billion at the end of 2007, Fed data show.

Traders have speculated the Fed will follow the ECB, pushing short-term rates lower in the U.S., according to Jim Lee, head of U.S. derivative strategy at Royal Bank of Scotland Group Plc’s RBS Securities Inc. in Stamford, Connecticut. The fed funds effective rate fell to 14 basis points on July 27 from 17 basis points on July 5. A basis point is 0.01 percentage point.

“Part of the reason for the demand this month for short-term U.S. debt has been due to speculation that the Fed will cut the IOER following the ECB’s move and given the lack of disruptions in European money markets,” Lee said in an interview, referring to the interest rate on excess reserves.

The yield on the two-year Treasury note was 0.24 percent on July 27, down from 0.29 percent on July 5, while the implied yield for eurodollar futures that expire in December has fallen about 10 basis points during the period. The rate is based on expectations for three-month dollar Libor, or the London interbank offered rate.

Lottery Tickets

“Clearly the market is purchasing some lottery tickets in case the Fed does cut the IOER,” Lee said. The Fed has held the rate at 25 basis points since December 2008.

After the ECB’s cut, deposits at the central bank fell to 321 billion euros ($396 billion) on July 26, the least since Dec. 21.

The ECB’s move fuelled investor demand for short-term sovereign debt from the region’s safest nations, including Germany, Austria, and Finland, driving rates lower, with some of them falling below zero for the first time. Investors holding debt with a negative yield to maturity will receive less than they paid to buy the securities.

The central bank’s action hasn’t caused significant disruptions in European markets, said Alex Roever, head of short-term fixed-income strategy at JPMorgan in New York.

Market Stability

Market stability following the ECB’s move has probably prompted Bernanke to reconsider, Feroli said. Rising short-term borrowing costs may have also made the tool more appealing.

The fed funds effective rate — at 14 basis points on July 27 — has increased from six basis points at the end of September. That month the Fed announced its Operation Twist plan extending the average maturity of bonds in its portfolio by selling short-term securities and buying longer-term debt.

Also, the average rate for borrowing and lending Treasuries for one day through repurchase agreements, or repos, rose to as high this year as 0.297 percent on July 2, from minus 0.001 percent at the end of last year, a Depository Trust & Clearing Corp. index of General Collateral Finance repos shows. The rate was 0.172 percent on July 27. Securities dealers use repos to finance holdings and increase leverage.

Size of Cut

If Bernanke decided to lower the deposit rate, he would probably reduce it by about 10 or 12 basis points, instead of to zero, Feroli said.

A reduction may pose fewer political disadvantages than Bernanke’s other stimulus options, including an expansion of the Fed’s balance sheet. The central bank’s purchase of $2.3 trillion in securities during two rounds of so-called quantitative easing has drawn fire from lawmakers, including House Speaker John Boehner, an Ohio Republican, concerned about inflation risks.

In contrast, some lawmakers have urged Bernanke to stop paying interest on reserves.

“What you’re actually doing by this is sort of incentivizing the banks” to “keep their excess reserves at the Fed,” Representative Scott Garrett, a Republican from New Jersey, said to Bernanke during Feb. 29 congressional testimony by the central bank chief. “Isn’t that sort of counter to what your policy should be?”

Bernanke said the benefits from a rate reduction would be “pretty small.” Also, a cut would risk triggering some “financial side effects.”

Other Tools

The Fed’s other stimulus tools include altering the language on the outlook for interest rates and using the so-called discount window for direct lending to banks, Bernanke said in July 17 congressional testimony.

“That’s a range of things that we could do,” Bernanke said. “Each one of them has costs and benefits, and that’s an important part of the calculation.”

An IOER reduction alone probably wouldn’t buoy economic growth, said George Goncalves, head of interest-rate strategy in New York at Nomura Holdings Inc., a primary dealer.

The Fed may make the cut “in combination with a change in communication policy” extending the Fed’s commitment to hold the main interest rate close to zero beyond late 2014, or paired with another round of quantitative easing, Goncalves said.

Source: Bloomberg