By Pedro Nicolaci da Costa
RICHMOND, Virginia (Reuters) - A growing scandal surrounding manipulation of a key benchmark interest rate is feeding public anger towards banks, Richmond Federal Reserve bank President Jeffrey Lacker told Reuters in an interview on Friday.
The debacle over the setting of the London interbank offered rate, a global benchmark for $550 trillion of interest rate derivatives contracts, has already cost Barclays' CEO Bob Diamond and other top executives at the London-based bank their jobs and the fallout continues to broaden.
On Friday, the New York Federal Reserve Bank released emails that showed its then-president, Timothy Geithner, was told about problems with Libor in 2008 - including that some banks had indicated a tendency to under-report their borrowing costs - and he pressed the Bank of England to take action. Geithner is now U.S. Treasury secretary.
Lacker told Reuters the procedures used for determining the rate, in which financial institutions submit borrowing cost estimates rather than their actual borrowing rates, was ripe for abuse.
"If you just looked at it, without having read any of these stories, you'd suspect that it provides some measure of discretion within narrow margins to an individual institution as to what they report," he said during the interview in his Richmond office, which overlooks the James River.
In the wake of a global financial crisis that continues to reverberate in Europe, Lacker saw the developments as another blow to perceptions of Wall Street.
"The revelations broadly are another episode that is damaging to people's confidence in the financial services industry and that's a shame," he said.
Although the U.S. economy clearly weakened in the second quarter, Lacker was not concerned that the country would slip back into recession. Instead, he sees growth averaging about 2 percent, somewhat softer than he believed earlier in the year.
U.S. gross domestic product expanded at just a 1.9 percent annual rate in the first quarter and many economists believe conditions deteriorated further in the April to June period. Employment growth certainly slowed sharply, from a monthly average of 226,000 in the first quarter to just 75,000 per month in the second.
Still, Lacker, an inflation hawk who has dissented against every Federal Open Market Committee decision so far this year, said there was not much more monetary policy could do to help growth along.
"The thing I worry about is that expectations for what the Federal Reserve - what any central bank can do for real growth and labor market outcomes - have become overinflated," he said.
Still, Lacker downplayed concerns that purchases of government bonds by the central bank could hurt the functioning of the U.S. Treasury market, a worry raised by some other Fed policymakers at a meeting in June.
"If we wanted to expand our balance sheet that would be a minor byproduct that I think markets can adapt to," he said.
Lacker argued that one of the biggest achievements of new financial reform legislation was to hone in on the problem of banks that are too big to fail. He said so-called "living wills" from banks that outline how they could be wound down if their financial health came into question were key to that effort.
In response to the worst financial crisis and recession in generations, the Fed slashed overnight borrowing costs to effectively zero and bought some $2.3 trillion in government and mortgage-backed bonds to push long-term rates lower.
In June, the Fed announced it was extending a program known as Operation Twist, where it swaps short-term securities in its portfolio for longer-term ones to exert more downward pressure on long-term rates.
While that measure does not expand the Fed's $2.9 trillion balance sheet, many analysts expect the economy will weaken sufficiently to warrant a third round of so-called quantitative easing through outright bond purchases, or QE3, further bloating the Fed's securities portfolio.
Some economists believe mortgage-backed securities could be the focus of such a program. But not if Lacker, who has always opposed Fed interventions in that market, can help it.
"I think it amounts to choosing to channel credit to a (particular economic) sector and I think the flip side of that is, if it has any effect ... in that sector, it must be having some countervailing cost to some other sector," he said. "I favor a policy of the Federal Reserve holding only U.S. Treasuries as assets."
(Reporting by Pedro Nicolaci da Costa; Editing by Tim Ahmann and Andrea Ricci)