MNI SOURCES: Fed In Key Debate Over How It Sets Interest Rates

--Fed Discussing Whether To Switch From Floor System To Corridor

--Decision Will Have Implications For Balance Sheet

By Pedro Nicolaci da Costa

     WASHINGTON(MNI) - The U.S. Federal Reserve will actively debate at next

week's meeting whether to change the way it sets interest rates, according to

sources with knowledge of the deliberations.

     The choice between the current "floor system" of two operating interest

rates or a "corridor system" like the one that existed before the financial

crisis, will affect not just the mechanics of how the Fed sets interest rates

but also the ultimate size of its giant balance sheet.

     The November meeting, at which no interest rate increase is expected,

provides a good window for discussion of such seemingly technical but

market-relevant issues, including what the Fed considers the optimal size of its

bond portfolio, which peaked at $4.5 trillion and has since declined to $4.1

trillion.

     A shift in the Fed's operating framework back to a corridor system would

mean it might have to reduce its balance sheet more than market participants

currently expect, and traders say it could lead to greater volatility in

short-term interest rates.

     --OFFICIALS MAY FAVOR FLOOR, BUT DECISION NOT CLEAR

     Top officials appear to favor the path of least resistance, which would

mean keeping the current system with a large amount of bank reserves, sources

told MNI. But the decision is by no means set in stone and investors will be

looking to minutes for the central bank's November meeting for clues.

     Central bank officials have made clear the time was coming to reevaluate a

system for setting interest rates implemented during the financial crisis, just

before the Fed began to purchase large amounts of Treasury and mortgage-backed

securities in response to the 2008 market shock.

     With the federal funds rate now sometimes nudging closer to the interest

the Fed pays on bank reserves, which is supposed to act as a rate ceiling,

further delay could be problematic.

     The question is whether it should retain a "floor system" of interest

rates, with the interest on excess bank reserves as the main target rate and the

traditional federal funds rate as a floor, or return to a pre-crisis-like

corridor, in which the federal funds rate represented the midpoint between an

interest on reserves that was permanently set at zero and a fluctuating discount

rate.

     --RISK OF VOLATILITY

     At stake is how much control the Fed can continue to exert over short-term

interest rates without risking volatility that could have an adverse effect on

markets.

     New York Fed President John Williams, whose regional central bank leads

open market operations and is pivotal to the framework debate, last month

described the choice as between a "return to a system similar in spirit to that

used before the financial crisis, in which the supply of reserves in the banking

system was kept relatively scarce, and the interest rate was set by adjusting

reserves on a frequent basis through open market operations" or continuing "with

the system that we've been using since the crisis, in which bank reserves are

abundant and the federal funds rate target is achieved through adjustments to

administered rates."

     Williams appeared to lean toward the floor approach which he said "has

proven to be easy to communicate and adaptable" but added that it was a

committee decision: "The Fed will be looking closely at these options in the

coming months and will subsequently make a decision on the future operating

framework."

     In a speech last week, Cleveland Fed President Loretta Mester said the

Federal Open Market Committee would "soon be resuming a discussion of what that

implementation framework will be."

     She worried a large balance sheet could raise the risk of political

interference. It "might be viewed with some skepticism or generate requests for

the Fed to aid other industries or use the balance sheet to fund government

initiatives, as occurred during and since the crisis."

     But Mester added that "this type of risk can be effectively handled by

clear and timely communication by the FOMC on the rationale for its decision

about the implementation framework, as well as its other policy decisions in

pursuit of our goals of maximum employment and price stability."

--MNI London Bureau; +44208-865-3829; email: Jason.Webb@marketnews.com

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