US Fed may decide on new interest rate tool this week

New York, There is a distinct chance US Federal Reserve officials will rewrite their strategy for normalising monetary policy this week given signs that a roller-coaster debate over a new tool for controlling interest rates is nearing its resolution.
Investors worldwide are watching the US central bank’s policy meeting that ends on Wednesday for hints on when it will start raising borrowing costs. But perhaps as importantly, officials may finally update a 2011 blueprint for a gradual tightening of the Fed’s ultra-loose policy and shrinking its swollen asset portfolio.
Many Fed officials, economists and financial market participants once believed the so-called overnight reverse repurchase facility, which has been tested for a year, would become the main lever for steering interest rates and play a central role in a new monetary policy framework.
However, after a long debate over the merits and potential risks of the new tool the Fed appears close to a compromise limiting the use of the facility, Fed and industry sources say.
In a reverse repo – a tool used by other central banks, but new for the Fed in such an unlimited capacity – the central bank offers Treasury securities in exchange for cash from banks, money market funds and mortgage finance agencies, effectively paying them to park funds with the Fed.
Traditionally, the Fed does business only with a select group of banks, so the broad range of participating institutions raised stability concerns among central bankers.
Minutes from previous meetings show Fed officials are close to agreeing on “exit principles”, which they want to publish long before they start raising rates. A compromise on the new tool could pave the way for the plan to see the light Wednesday afternoon, though it is not clear if all differences have already been ironed out.
“To me it would make sense, if we can achieve it, to do it in September, but we’ll see,” Dallas Federal Reserve Bank President Richard Fisher said in an interview in early September.
Officials at the US central bank’s influential New York branch had big plans for the new facility, designed to help drain the vast pool of reserves the central bank has created trying to revive the economy in the wake of the global financial crisis.
But reservations among policymakers elsewhere in the country made it a sticking point in the effort to rewrite the exit principles that would guide any policy tightening.
Like other officials, Fisher has yet to give the new tool a full embrace and Fed minutes show he is not alone.
“It has utility, but we have to be careful in deploying it,” he said. “I think we have to be careful that we don’t become party to anything that could in any way shape or form… Have financial repercussions that we did not foresee.”
UPS AND DOWNS
As the New York branch of the Federal Reserve ramped up testing of the overnight reverse repo late last year, banks, funds and other market players started preparing for a major new Fed presence in short-term funding markets.
In December, Simon Potter, head of markets at the New York Fed, said the tool’s users were telling his team it would effectively control money market rates “if executed in full scale in the future.”
“When it first came through everyone thought it would be integral to monetary policy,” said Gennadiy Goldberg, a strategist at TD Securities.
But in January the Fed’s policy-setting committee decided that its chair – Ben Bernanke at the time and now Janet Yellen – would approve any subsequent changes to the new rate during the testing, an apparent effort to wrest some control of the facility from the central bank’s New York branch.
Later in March, just a few blocks from the New York Fed’s headquarters, Philadelphia Fed President Charles Plosser told an audience of bond traders that the committee, and not the New York Fed’s open markets desk, would ultimately decide its fate.
How to drain more than $3 trillion of funds pumped into the economy since 2008 without causing market upheaval and hurting economic recovery is the ultimate challenge for the Fed.
The new facility has been a key topic in at least three policy-setting committee meetings since April and officials could still delay the publication of the exit principles if they decide the tool needs more testing.
One chief worry has been that giving money market funds unlimited access to the new facility could spark “runs” from more risky assets in times of financial stress.
Another concern is that it would align the Fed too closely with the non-traditional – and possibly more risky – funds, and cut out the banks.
By July, most officials appeared to agree that reliance on the tool should be limited and temporary.
The key policy rate, they agreed, should remain the rate on overnight lending between banks known as the fed funds rate. The federal funds rate would be pinned within a quarter percentage point corridor, with the rate paid to banks on excess reserves held at the Fed serving as the ceiling, and the reverse repo rate acting as a floor.
But to curb demand for the latter the Fed now plans to pay a rate further below the target rate than officials had earlier envisioned.
“This is a far cry from the original plan,” former Fed Governor Laurence Meyer co-wrote last month in a note for Macroeconomic Advisers.
(Reuters)

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