By Karen Brettell
NEW YORK (Reuters) - Talk that banks may lose an interest rate perk for parking excess cash with the Federal Reserve was revived on Thursday, after Janet Yellen said the U.S. central bank may consider cutting the rate.
The Fed introduced the Interest on Excess Reserves rate (IOER) during the depths of the financial crisis in 2008 as a means of helping the central bank control short-term interest rates. Excess reserves at the Fed have ballooned to around $2.3 trillion, from near nothing before their introduction, Fed data shows.
The Fed pays banks 0.25 percent interest on excess cash held at the Fed, much higher than the market Fed funds rate for banks lending to each other overnight, currently about 0.09 percent.
The rate has been criticized, however, for encouraging banks to park cash idly with the central bank instead of using funds to lend to companies and consumers that many say is needed to stimulate the economy and reduce unemployment.
Yellen, who has been nominated to succeed Fed chair Ben Bernanke at the end of January, said on Thursday that cutting excess reserves is "something that the FOMC has discussed, and the board has considered, on past occasions, and it is something we could consider going forward."
Market speculation that the Fed may be nearer to acting on a cut also increased on Thursday after influential firm Medley Global Advisors said in a report that the Fed may cut the excess reserve rate, noting that it has more flexibility to do so now that it has been testing its reverse repurchase agreement program.
In reverse repos, the Fed temporarily drains cash from the financial system by borrowing funds overnight from banks, large money market mutual funds and others, and offering them Treasury securities as collateral. This helps the Fed control short-term rates as the supply of collateral can stop market disruptions from rates falling to zero or into negative territory as cash floods into short-term markets.
The Fed has been testing this program since September.
"The logic for cutting the IOER now, would be to better align the IOER with other short-term rates and hopefully encourage greater market-based lending," said Kenneth Silliman, head of short-term rates trading at TD Securities in New York.
"With the creation of reserve draining facilities, like the Overnight Reverse Repo Facility, the Fed now has the ability to better align rates without destabilizing money markets given that the Fed can essentially put a 'floor' on short-term rates by injecting collateral/draining reserves into the market. This would have a stabilizing effect," he said.
Some market participants remain concerned, however, that cutting the interest the Fed pays on excess reserves would not encourage more bank lending, but instead lead to more cash flooding into money funds, pushing down rates and hurting savers' returns even with the reverse repo facility.
Yellen also noted concerns about money market disruptions in her comments on Thursday.
"We've worried that if we were to lower that rate too close to zero we would begin to impair money market function. And that's been the consideration on the other side. But it certainly is a possibility," she said.
Narayana Kocherlakota, president of the Minneapolis Fed, also raised the possibility of cutting the rate this week as an option to spur greater economic activity.
"Under a goal-oriented approach, the committee would respond to (a) weak outlook by providing more monetary stimulus - for example, by lowering the interest rate being paid to banks on their excess reserves," Kocherlakota said.
(Editing by Steve Orlofsky)