One Fed tool that gives Wall Street heartburn
WASHINGTON (MarketWatch) -- Wall Street is enthusiastic about the prospect of more Federal Reserve easing but want the central bank to jettison one tool: reducing the interest rates paid to banks for reserves they park at the Fed.
At the moment, the Fed pays banks 0.25% for reserves they park at the Fed. These reserves currently total $1.46 trillion.
Proponents of the measure say that cutting the rate would make banks work harder to make loans.
Opponents don't think the measure will have much benefit and are worried it could harm the $2.7 trillion money-fund industry.
The idea of cutting the interest on excess reserves first was floated last fall but was rejected at the time. See story about Fed easing options last September
Since then, Fed officials have said that the rate will be a key tool in their exit strategy from the ultra-easy monetary policy because they can use it to keep too much money from flooding into a healthy economy.
But speculation of a cut in interest paid on excess reserves increased early this month after the European Central Bank lowered its deposit rate. Read more about ECB rate cuts
Fed Chairman Ben Bernanke listed the possibility as a potential tool to stimulate the economy in his testimony to Congress last week.
Analysts think the Fed is inching closer to easing again out of a concern that the economy is in deeper trouble than expected.
Questions remain about exactly how and when the Fed will act. Fed policymakers meet again on July 31-Aug. 1.
The leading option for easing at the moment is another round of bonds purchases, including mortgage-backed securities, which would be the first purchases of MBS since 2010.
Wall Street thinks cutting interest of excess reserves would disrupt short-term bond markets and potentially harm money-market funds.
With no interest payments, banks would seek to divest excess reserves and this would lead to declines in yields of short-dated securities such as fed funds, Treasury bills and commercial paper.
Money-market funds are already "scraping by" and if yields drop into negative territory, "there is a question whether a lot of those funds will be viable," said Anthony Valeri, investment strategist for fixed income for LPL Financial.
"Eliminating interest on reserves would likely do more harm than good," added Lou Crandall, chief economist at Wrightson ICAP LLC, in a report.
Brian Smedley, a rate strategist with Bank of America Merrill Lynch, said these technical considerations make a cut in excess reserves "virtually impossible."
Some academics dismissed these fears.
Catherine Mann, an economics professor at Brandeis University, favors cutting the interest rate on reserves to zero.
"Credit conditions are still extremely tight for the bank-dependant part of the economy," such as small businesses, Mann said.
Before the financial crisis, small firms and start-ups used to finance their operations with real estate. This type of lending remains "dead in the water," Mann said.
The Fed only received the power to pay excess reserves in the fall of 2008 and lowering it to zero would be "a return to normalcy that has eluded us for some time now," Mann said.
Some analysts think the interest on reserves is too small a tool given the problems facing the economy.
Ann Owen, an economist professor at Hamilton College, said that she was sceptical that "all of a sudden there would be new investments" that were not worth making if the interest on reserves was 25 basis points higher.
"It is doubtful to have a big impact," Owen said.
The problems holding back the U.S. economy are the state of the European economies and U.S. fiscal policy, Owen noted.
"The idea that banks would rather get 25 basis points from the Fed rather than make loans is ridiculous," said Jim Glassman, economist with J.P. Morgan Chase.
Nathaniel Karp, chief economist for BBVA Compass, said the Fed's response to the mounting economic woes "will have to be something more aggressive and bolder than just lowering interest on excess reserves."
"If they do something along those lines. it would have to be along with some other measures." Karp added.
Former Fed Vice Chairman Alan Blinder said that if cutting the interest on excess reserves to zero doesn't work, the Fed could even drop the interest rate on excess reserves to a negative 0.25%.