The U.S. Federal Reserve looks set to end its reliance on the federal funds rate, long its primary monetary policy tool, when the time comes to tap the brakes as the economy recovers.

Set to take its place is the interest rate the Fed pays on excess bank reserves, a tool the central bank has more control over, particularly in the current financial environment.

With the financial system awash in cash, the central bank could find it more difficult than usual to control the federal funds rate. That puts interest on excess reserves -- a tool it can influence directly -- front and center.

In a situation where the Fed does not or cannot or is unwilling to bring down the level of excess reserves, the Fed will not be able to target the fed funds rate directly with monetary policy, said Carnegie Mellon University professor Marvin Goodfriend, a former Richmond Federal Reserve Bank economist.

Most likely the Fed will look to the interest paid on excess reserves as the indicator of the stance of interest rate policy, he said.

The Fed has pumped more than $1 trillion into the economy since mid-2007, more than satisfying the banking system's appetite for reserves.

Banks hold reserves in excess of requirements on deposit with the Fed, with another bank or in their own possession.

Because of this, trading has fallen off in the federal funds market, where supply is now dominated by mortgage enterprises Fannie Mae and Freddie Mac, who unlike banks, can not earn interest on balances at the Fed.

If the Fed continued to focus on the federal funds rate, it could have a hard time hitting its target because Fannie Mae and Freddie Mac would continue to accept lower rates on their excess. While the Fed is currently paying 0.25 percent interest on excess reserves, the federal funds have been trading around 0.10 percent.

In addition, the thinning of the market and the fact that the market fails to capture some bank-to-bank lending undercuts the federal funds rate use as a borrowing cost benchmark.

In normal times, the federal funds rate would more fully capture firms' costs of overnight borrowing, making it a good foundation from which to calibrate other interest rates.

Now, in an environment of interest on reserves, where very few transactions are being conducted in the fed funds market, it becomes questionable whether that is still the case, said Michael Feroli, a former Fed economist now with JPMorgan Chase in New York.

These factors have conspired to make the federal funds rate less of a good indicator of financial conditions in the eyes of Fed officials, who are likely to abandon it, at least temporarily, in favor of tools it can influence more directly.

The new benchmark would be the interest on excess reserves -- or IOER.

When the central bank begins to exit from its extraordinary monetary easing, expect the statements following its policy meetings to refer to the IOER rate, possibly alongside reserve-draining actions, or targets for reserves.

(Reporting by Mark Felsenthal; Editing by Andrew Hay)

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