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BLBG: Fed Sets Floor Below Rate Target, Engineering `Stealth' Cut
By Scott Lanman

Oct. 7 (Bloomberg) -- The Federal Reserve may have trimmed borrowing costs yesterday without actually saying so.

The central bank used power granted under last week's financial-rescue legislation to effectively set a floor under its main interest rate that's lower than the 2 percent target set by policy makers last month. The Fed may now pay interest on bank reserves while it floods financial markets with liquidity, pushing down the overnight lending rate by about 0.75 percentage point to 1.25 percent.

``Absolutely, it's a stealth easing,'' said John Ryding, founder and chief economist of RDQ Economics LLC in New York and a former Fed researcher.

The announcement, and a Fed decision to double the auction of cash to banks to as much as $900 billion, failed to avert a 3.9 percent decline yesterday in the Standard & Poor's 500 Index. The index has tumbled 28 percent this year even as the central bank has expanded credit more than at any time in seven decades, including a 3.25 percentage-point cut in the main rate during the past 13 months.

``The problem is it's an easing that's trying to offset a massive tightening in the market. Net-net, are we easier in policy? In some sense the answer is no,'' Ryding said.

By paying interest on reserves, the Fed can pump more cash into the financial system without worrying the overnight lending rate will drop to zero at the end of each day as banks withdraw excess reserves. The move doesn't preclude a further reduction in the target rate by the Federal Open Market Committee.

Biggest Surprise

The 0.75-point spread, announced yesterday, was the biggest surprise in the Fed's moves to implement its authority under the financial-rescue legislation, economists said. The Fed set the new rate Oct. 3, the same day the House approved the bill and President George W. Bush signed it into law.

The FOMC, composed of the Washington-based governors and 12 Fed regional-bank presidents, meets about every six weeks to set a target for the overnight lending rate, which the New York Fed tries to achieve by buying and selling Treasury securities from bond dealers.

The Fed requires banks to keep a level of reserves at the central bank. On those funds, the Fed will pay a higher rate equal to the average target rate over a one or two-week period less 0.10 percentage point. For excess reserves, the rate is the lowest FOMC target over a period less 0.75 percentage point.

The Fed said it would raise or lower the spread so the New York Fed trading desk can keep the federal funds rate near policy makers' target ``based on experience and in response to evolving market conditions.''

The central bank didn't set a meeting schedule for discussing the reserve-interest rate.

Channeling Cash

The federal funds rate will probably trade below the FOMC's target as long as the Fed is channeling cash into the banking system, thereby prompting financial institutions to park their funds with the central bank each day. The rate may trade closer to the policy target when the credit crisis eases and the Fed begins to withdraw its emergency lending.

Still, a ``soft federal funds rate does not provide a perfect substitute for a cut in the target,'' former Fed Governor Laurence Meyer and former Fed researcher Brian Sack, now with Macroeconomic Advisers LLC in Washington, said in a research note to clients.

The Fed said yesterday ``the rate on excess balances should be set sufficiently low to provide an incentive for eligible institutions to trade funds in excess of required reserve balances and clearing balances in the federal funds market.'' The rate should also discourage banks from trading funds ``far below'' the federal funds rate.

The interest payments begin Oct. 9.

Start Lending

A higher rate on payments may give banks too much of an incentive to keep funds at the central bank, said Peter Hooper, chief U.S. economist at Deutsche Bank Securities Inc. in New York and a former Fed official. ``The whole objective here is to get banks to start lending again, and the more you pay them to hold on to their reserves, the less likely they'll be willing to lend.''

Even if the funds rate trades below the 2 percent target, it doesn't mean the FOMC is deploying a new policy tool by paying interest on reserves, said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York. ``I doubt the FOMC will want to give up their Fed funds rate target as the key indicator of monetary policy.''

To contact the reporter on this story: Scott Lanman in New York at slanman@bloomberg.net