Fed may have to ramp up reverse repos to raise rates: EVP Potter

[NEW YORK] The Federal Reserve may have to do a lot more trading with money-market mutual funds than it does now to raise interest rates when the time comes, said Federal Reserve Bank of New York Executive Vice President Simon Potter.

The amount of borrowing it does from those funds "could conceivably be much greater than what we have seen at higher levels of interest rates," Mr Potter, who runs the team responsible for the implementation of US monetary policy, said Wednesday in remarks prepared for delivery in New York.

When the Fed decides to raise rates for the first time since 2006, Mr Potter's group faces the challenge of executing that directive in a banking system that has been flooded with US$2.6 trillion in excess reserves over the last six years.

These reserves, which were created by Fed asset purchases designed to hold down borrowing costs and spur the economy, will make it harder to control the central bank's benchmark federal funds rate. That has prompted the Fed to develop new tools to lift rates from near zero when the time comes. Most officials expect to begin raising rates later this year.

Chief among the tools is the Fed's overnight reverse repurchase agreement facility, which will help put a floor under interest rates by sopping up liquidity outside the banking system.

In an overnight reverse repo, the central bank borrows cash from counterparties, mostly money-market mutual funds, and posts securities from its bond portfolio as collateral. The next day, the Fed returns the cash plus interest at a specified rate and takes back the bonds.

The Fed has been testing overnight reverse repos at a 0.05 per cent rate, limiting daily transactions to US$300 billion. When the central bank eventually lifts rates, it will do so by raising the reverse repo rate to 0.25 per cent and temporarily increasing or suspending the US$300 billion cap, according to minutes of the policy-setting Federal Open Market Committee's latest meeting in March.

"Many participants agreed that an elevated aggregate capacity for the facility would likely be appropriate only for a short period after liftoff," according to the minutes.

Officials have expressed concern that offering too many reverse repos to money funds for too long could drain business away from the funds' traditional repo market counterparties. That might harm those relationships, which form a vital part of the plumbing of the financial system. Moreover, the presence of the Fed as a risk-free counterparty could exacerbate strains on bank funding in times of future crisis.

In response, analysts from Barclays to Goldman Sachs Group worry that the current cap would be too small to prevent rates from falling when officials want them to climb, and that their hesitancy to embrace a higher volume of reverse repo transactions may lead to more volatility in money markets when the Fed begins raising interest rates.

The central bank will probably have to conduct more than US$1 trillion of reverse repos each day to exert adequate control over rates after liftoff, according to Wrightson ICAP.

Mr Potter stressed that policy makers will retain flexibility in their approach and make changes to maintain control if necessary.

While the current US$300 billion limit "has generally provided sufficient capacity to establish a floor on the level of money market rates, it is difficult to know ex ante whether the same amount will be adequate once we move away from the zero lower bound," he said.

"Providing capacity that market participants will judge sufficient to meet demand with a high degree of certainty can therefore enhance the confidence of policymakers and market participants that the facility will support short-term interest rates at the time of liftoff."

BLOOMBERG