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What the Fed should do (but probably won't)

September 11, 2012: 10:32 AM ET

The Fed's efforts to spur borrowers to get loans have not worked. Perhaps it's time to reverse engineer it, by spurring banks to lend instead.

ben_bernankeFORTUNE -- When Fed policymakers meet this week, many investors expect the central bank will announce additional steps to bolster the U.S. economy – either by launching another round of bond buying or assuring that interest rates will stay super low for a longer period of time. The Fed could also embark on a mix of both actions.

But as we recall, it has tried similar moves before. Not once, but twice.

And while the Fed's bond-buying bonanza has helped drive down the costs of home loans to record lows, economic growth has remained tepid at best: The housing industry is far from recovered (though Fed Chairman Ben Bernanke's financial disclosures recently revealed that he refinanced his Washington home at a lower interest rate) and unemployment is still unnervingly high. Besides, while the central bank's low interest rate policies may have benefited borrowers, it has hurt savers.

The Fed must try something new, starting with getting banks to lend more. Stocks have risen on signs that officials may launch another round of bond buying, but as The Wall Street Journal highlights, investors increasingly doubt the rally will last. The Fed has essentially been using the same bag of tricks in the sense that it has been trying to lure consumers and business to borrow more. But while rates on 30-year fixed mortgages have been well below 4% since January, try actually getting a home loan from a bank with mediocre credit or an underwater mortgage.

MORE: Can the middle class thrive without home ownership?

Former Fed vice chairman and Princeton University economics professor Alan Blinder has urged policymakers to lower the interest rate that the Fed pays to banks for keeping its deposits with them. Blinder's reasons to lower the rate makes sense, and echoes others including St. Louis Fed President James Bullard. Currently, the Fed pays 0.25% to banks. This is small, but the thinking is that lowering that rate further could get banks to lend its reserves elsewhere and therefore actually make money on the loans. And if the Fed lowers the rate to negative levels, banks would effectively be paying the central bank to store their money.

Admittedly, it's uncertain if the move would spur much more lending. Since the Great Recession, U.S. corporations faced with an uncertain economy have been sitting on record levels of cash rather than doing much spending on new hires or investing. How might this be any different for banks? What's more, many Fed officials haven't warmed up to the idea. They worry it could hurt money market mutual funds, as well as freeze up loans that banks and mortgage agencies such as Fannie Mae and Freddie Mac make overnight to each other.

Blinder doesn't think lowering rates will hurt the financial system. He points to the European Central Bank and Denmark's National Bank, both of which have cut the rate it pays on bank deposits. "They're still standing," he says.

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If it sounds odd at all that the Fed pays interest to banks on reserves, know this wasn't always the case. The policy started amid the financial crisis in 2008 when banks built up lofty reserves as the Fed flushed the economy with money. To cushion the central bank from economic havoc, a law passed requiring that banks leave a small portion of its cash on reserve at the Fed. It's true the safety net is needed, but U.S. banks are holding about $1.6 trillion in excess of what they need to back their deposits at the central bank.

The point is the economy is clearly caught in a liquidity trap. Consumer have an appetite for loans, but the Fed's policies for the past few years overlook the other equation – the willingness of banks to lend.

Another way to see it: What doesn't hurt the financial system could only help it. And at this point, wouldn't it be worthwhile to try something different?

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About This Author
Nin-Hai Tseng
Nin-Hai Tseng
Writer, Fortune

Nin-Hai Tseng covers economics and finance. Before joining Fortune, Tseng was a reporter at The Orlando Sentinel and a public affairs associate at GE. She holds an MPA from Columbia University and a BS in Journalism from the University of Florida. She lives in New York City.

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