Concerns Emerge as a Fed Rate Falls

• By JON HILSENRATH And MARK GONGLOFF

A sharp and unintentional decline in the Federal Reserve's key interest rate in recent days is raising eyebrows in financial markets and shining a light on the challenges the central bank could face steering monetary policy in the months ahead.

The federal-funds rate, an overnight bank lending rate that affects borrowing costs throughout the economy, has fallen to 0.09% from 0.13% in the past week and from 0.2% in late December.

While the numbers are small, such movement is unusual. The Fed's target for this rate is between zero and 0.25%, but the rate has generally held close to the high end of that range since the central bank set it in December 2008.

This is the Fed's key policy rate and the Fed usually finds it easier to control its moves. When it wants to fend off inflation, it raises this rate to tighten policy. But a confluence of events, including the cash it has pumped into the financial system, threatens to make this task more complicated.

"The folks at the Fed tell us they have the tools to exit, but are they going to work properly?" said Raymond Stone, of Stone & McCarthy Research Associates, an economic and market-forecasting firm. "I don't believe anybody really knows."

The funds rate has been falling since November, when the Fed began its program to buy $600 billion in Treasury debt, known as quantitative easing, or "QE2."

Fed officials—especially at the markets desk of the Federal Reserve Bank of New York—are watching closely. They still have strong confidence that they can manage the rate as needed. It isn't clear the Fed would want to do anything about the downward drift in the funds rate now. Fed Chairman Ben Bernanke made clear earlier this week that he isn't ready to tighten policy.

The fed-funds rate has suffered other precipitous declines in recent years, typically for a day or two at the end of quarters, but it usually snaps back. This time it has stayed low, echoing other short-term lending markets, where a host of factors have combined to drive rates lower in recent days.

The U.S. Treasury has drawn down $200 billion in deposits it had been holding with the Fed, adding to the money in the banking system. (supply increases)

Moreover, a new fee on bank liabilities imposed by the Federal Deposit Insurance Corp. has given banks less incentive to borrow in the fed-funds market, putting further downward pressure on the rate. (charge on short term liabilities like repos beside deposits) The FDIC fee is a new wrinkle Fed officials will need to consider as they map out their tightening strategy, but most analysts dismiss its long-term import. (demands decreases)

The Fed is counting on a relatively new tool to manage the fed-funds rate when the time comes to tighten—its ability to pay interest to banks on the reserves that they keep on deposit with the central bank. That rate is now 0.25%.

When the Fed wants to tighten policy, the thinking goes, it can raise this rate, giving banks more incentive to keep money tied up with the Fed and less incentive to put it to work in the fed-funds market. That, in turn, will tighten conditions in the fed-funds market and pull the fed-funds rate up with the rate on excess reserves.
Many Fed officials are confident that the ability to pay interest on excess reserves will be a powerful tool, and potentially their main tool, when they want to raise short-term rates and seem likely to see the latest moves as manageable. However, recent experience shows the fed-funds rate doesn't always align closely with the interest rate on excess reserves.

Even before the latest drift down in the fed-funds rate, some officials were worried that the Fed had flooded the financial system with so much cash that short-term lending markets, and especially the fed-funds market, could behave in unexpected ways when the time for tightening monetary policy comes.

The market's recent behavior suggests that, when the Fed starts to tighten, the fed funds rate might drag its feet.

"There are steps they can take to correct for that," said Dan Greenhaus, chief economic strategist at Miller Tabak, "but it's one more complication that makes getting this right very difficult."

The Fed has several backup tools to tighten policy when it chooses to do so. For instance, its "term-deposit" facility will tie up bank funds at the Fed on a temporary basis to soak reserves out of the banking system. And it always has the option of trimming its balance sheet by selling its holdings of Treasurys or mortgage-backed securities.
Write to Jon Hilsenrath at jon.hilsenrath@wsj.com and Mark Gongloff at mark.gongloff@wsj.com