U.S. Rescue Bill Is Said to Expand Fed Power on Rates

U.S. Rescue Bill Is Said to Expand Fed Power on Rates

(Corrects fourth paragraph to remove reference to the effective rate.)

Sept. 28 (Bloomberg) -- Congress's $700 billion legislative compromise to revive credit markets would also expand the Federal Reserve's power to manage short-term interest rates.

The draft bill gives Fed authority as of Oct. 1 to pay interest on reserves held at the central bank by financial institutions, according to a copy obtained by Bloomberg News. That would encourage banks to deposit excess funds with the Fed rather than dumping them into the money markets and distorting its overnight federal funds rate.

``I expect them to use it to manage the funds rate more efficiently,'' said Lou Crandall, chief economist at Wrightson ICAP LLC, in Jersey City, New Jersey.

The flood of liquidity pumped into the financial system by the Fed to encourage interbank lending over the past year has made it harder for the central bank to gauge market conditions and keep fed funds at its 2 percent target. The rate has traded between zero and 7 percent since Sept. 15.

The Federal Open Market Committee sets a target for the federal funds rate, which the New York Fed is obligated to achieve on a daily basis through temporary and permanent purchases or sales of bonds in the open market. Banks are required to hold a proportion of their customers' deposits in an account at the central bank.

Bernanke Request

The Fed had already received authority to start paying interest on reserves in October 2011. Bernanke asked House Speaker Nancy Pelosi in May to expedite the authority. U.S. lawmakers are reviewing the $700 billion plan to buy troubled assets from financial institutions, and the House and Senate may vote tomorrow.

A measure of availability of cash among banks, known as the Libor-OIS spread, widened to the most on record 2.08 percentage points on Sept. 26. In the year before the credit crisis started in August last year, the spread averaged 8 basis points.

Commercial banks borrowed $39.4 billion from the Federal Reserve's discount window for the week ending Sept. 24, almost double the previous period, as the financial crisis deepened and funding from other banks dried up.

BLOOMBERG