Rosengren, a voting member of the Fed’s policymaking Federal Open Market Committee, said in an interview with Market News International that he will go into the Nov. 2-3 meeting with an “open mind” about whether or not the Fed should inject more monetary stimulus into the economy.

However, he made clear that he would favor a resumption of quantitative easing if the economy does not show improvement on both unemployment and inflation. Further deterioration is not necessary to justify Q.E. in his mind.

Rosengren was more dubious about the merits of changing the Fed’s communication strategy to raise inflation expectations and lower rates, saying he doesn’t perceive there to be a communication problem with the market. He was also skeptical as to whether cutting the already  bare-bones interest rate on excess reserves would accomplish much.

Paying IOR is another tool that has given greater discretion to the Fed, yet greater discretion is not without cost. A central bank may be motivated to pay IOR to overcome restrictions that hinder efficiency in financial markets. Yet, many overlook that paying IOR ties together the central bank’s balance sheet and the government’s budget constraint, since the interest is financed by government revenues.¹⁵ This may come at the cost of central bank independence.

Asked about the possibility that the Fed would lower the interest it pays on banks' excess reserves, currently at 0.25 percent, as a further step to stimulate growth, Bullard suggested the impact might be too small.

"I don't think it would be particularly effective. It's kind of a dead-end policy, you can only do it once," he said.

As reported by Reuters

One possible sequence would involve the Federal Reserve continuing to test its tools for draining reserves on a limited basis, in order to further ensure preparedness and to give market participants a period of time to become familiar with their operation. As the time for the removal of policy accommodation draws near, those operations could be scaled up to drain more significant volumes of reserve balances to provide tighter control over short-term interest rates. The actual firming of policy would then be implemented through an increase in the interest rate paid on reserves.

One option you might want to consider is that our policy rate is the interest rate on excess reserves and we let the fed funds rate trade with some spread to that.

In a Q&A session with journalists, as reported by Bloomberg News

What I’ve come to appreciate far better now after having had discussions, is that we have interest on reserves we can pay in the U.S.  That’s a relatively new tool.  Our initial experience in fall 2008 was not exactly perfect.  I think interest rates on excess reserves is one way to inject additional restraint on policy. 

You can do that even with a very large balance sheet.  We’d be learning about the effect of this tool.   We can do reverse repurchases.  We can sell assets. We can always do that. 

I’m confident that we can shift to a more restrictive policy when the time is approaching.  Presumably that’s an extended period beyond where we are now.

From comments to the press, as reported by Bloomberg News

The opportunity for banks to earn interest on a highly liquid risk-free deposit at the Federal Reserve should put a reasonably firm floor under short-term rates, including the federal funds rate. To date, that floor has been somewhat soft, perhaps because not all participants in the federal funds market can hold deposits at the Federal Reserve, and because banks have been reluctant to allocate the needed capital to arbitrage a few basis points. But I am confident that when we begin to raise our deposit rate, it will put upward pressure on the rates on competing assets, increasing actual and expected short-term interest rates with the usual types of effects on other interest rates and asset prices.

Although our ability to pay interest on excess reserves is sufficient to retain control of monetary policy, it is not bad policy to have both a “belt and suspenders” in place. As a result, we are working out ways to drain reserves to provide reassurance that we will not—under any circumstance—lose control of monetary policy.

The ability to pay interest on reserves is an important tool because, as I mentioned, it’s conceivable that, even if the economy rebounds nicely, the credit crunch might not be fully behind us and some financial markets might still need Fed support. This tool will enable us to tighten credit conditions even though our balance sheet wouldn’t shrink.

Some skeptics note that when interest on excess reserves was first implemented, the federal funds rate traded somewhat below the rate on excess reserves. This has created worry in some quarters that paying interest on excess reserves might not work very well as a tool for controlling the federal funds rate.

On this issue, two points are warranted. First, the relatively large gap between the interest rate on excess reserves and the federal funds rate was due, in large part, to the impaired condition of the banking system, which inhibited the willingness of banks to arbitrage that gap...

Second, the Federal Reserve could alter its monetary policy framework in order to increase its control of monetary policy in a large excess reserve environment. It is beyond the scope of this speech to get into the details, but we have plenty of options in devising incentives for banks to hold reserves at the Fed that would improve our ability to control the federal funds rate.

Indeed, the actual federal funds rate has been trading consistently below the Committee's 1 percent target in recent weeks, reflecting the large quantity of reserves that our lending activities have put into the system. In principle, our ability to pay interest on excess reserves at a rate equal to the funds rate target, as we have been doing, should keep the actual rate near the target, because banks should have no incentive to lend overnight funds at a rate lower than what they can receive from the Federal Reserve. In practice, however, several factors have served to depress the market rate below the target. One such factor is the presence in the market of large suppliers of funds, notably the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, which are not eligible to receive interest on reserves and are thus willing to lend overnight federal funds at rates below the target.¹ We will continue to explore ways to keep the effective federal funds rate closer to the target.

Addressing the mystery of why the federal funds rate has remained below the target, despite the Fed's policy of paying interest on reserves in order to set a floor, Kohn said, "So far that hasn't worked as well as I had hoped it would."

He speculated that the phenomenon "to some extent that reflects people getting used to a new system, banks getting used to and adapting to new systems.  "In order to bring that federal funds rate to the floor, somebody has got to be willing to buy funds from people who are selling it or would like to sell it below the floor and then put it to the Federal Reserve and that means expanding your balance sheet.  So I think the fact the federal funds rate has been somewhat below our target and somewhat below the rate we're actually paying on reserves reflects some of the stresses in the financial system," Kohn said. "Over time I would think that would provide a floor, and that wouldn't constrain our use of quantitative easing." 

He noted in response to another question on paying interest on reserves that the "excess reserves are a consequence of the problems private parties perceive in lending to each other. They're not a cause."

Recently, however, our liquidity provision had begun to run ahead of our ability to absorb excess reserves held by the banking system, leading the effective funds rate, on many days, to fall below the target set by the Federal Open Market Committee. This problem has largely been addressed by a provision of the legislation the Congress passed last week, which gives the Federal Reserve the authority to pay interest on balances that depository institutions hold in their accounts at the Federal Reserve Banks. The Federal Reserve announced yesterday that it will pay interest on required reserve balances at 10 basis points below the target federal funds rate, and pay interest on excess reserves, initially at 75 basis points below the target. Paying interest on reserves should allow us to better control the federal funds rate, as banks are unlikely to lend overnight balances at a rate lower than they can receive from the Fed; thus, the payment of interest on reserves should set a floor for the funds rate over the day. With this step, our lending facilities may be more easily expanded as necessary.

Although the Federal Reserve sees no need to pay interest on excess reserves in the near future, the ability to do so nevertheless would be a potentially useful addition to the monetary toolkit of the Federal Reserve.

The Board’s proposed amendment would authorize the Federal Reserve to pay explicit interest on contractual clearing balances and excess reserve balances, as well as required reserve balances. This authority would enhance the Federal Reserve’s ability to efficiently conduct monetary policy, and would complement another of the Board’s proposed amendments, which would give the Board greater flexibility in setting reserve requirements for depository institutions.  In order for the Federal Open Market Committee (FOMC) to conduct monetary policy effectively, it is important that a sufficient and predictable demand for balances at the Reserve Banks exist so that the System knows the volume of reserves to supply (or remove) through open market operations to achieve the FOMC’s target federal funds rate.