Fed to Sell Term Deposits to Ensure Exit ‘Readiness’

The Federal Reserve will sell term deposits in October and November and about every other month thereafter as it prepares for an eventual exit from the unprecedented expansion of the central bank’s balance sheet.

The “small-value offerings” in the Term Deposit Facility are a “matter of prudent planning and have no implications for the near-term conduct of monetary policy,” the Fed said in a statement today in Washington.

Policy makers led by Chairman Ben S. Bernanke are preparing for the day when they will have to start siphoning off more than $1 trillion in excess reserves from the banking system to contain inflation. The Fed is charting an eventual return to normal monetary policy, even as a weakening near-term outlook has raised the possibility it may expand its balance sheet.

“It’s clearly procedural, to make sure they have all their ducks in a row,” said Thomas Simons, a money market economist at Jeffries Group Inc. in New York, one of the primary dealers that trade directly with the central bank. “As far as policy is concerned, this has no weight whatsoever.”

The Fed will auction $5 billion in 28-day deposits on Oct. 4 and Nov. 29, according to the statement, larger than the $2 billion tests conducted this year. The increased size is “intended to encourage broad participation by depository institutions at the upcoming auctions,” the Fed said. The schedule and terms for auctions in 2011 will be announced later, the statement said.

‘Negative Signal’

“There is some value to keeping it in the backs of people’s minds that someday something is going to happen” toward an exit from stimulus, Simons said. “They told us a number of months ago they were going to do ongoing offerings, it would be bad if they didn’t do it anymore. That would be a very negative signal.”

The purpose of the auctions is to “ensure the operational readiness of the TDF and to provide eligible institutions with an opportunity to gain familiarity with term deposit procedures,” the Fed said.

The Term Deposit Facility and reverse repurchase agreements are among the programs the Fed has said they will deploy to raise their target interest rate for overnight lending among banks when the time comes. At the Fed’s Aug. 10 meeting, policy makers pledged to keep interest rates “exceptionally low” for an “extended period.”

Three Tests

The Fed has held three tests of the Term Deposit Facility since June, saying these tests also had no implications for the near-term conduct of monetary policy.

In exchange for leaving their money in the Term Deposit Facility, banks receive a premium on their funds. In the first two auctions, winning banks received interest of 0.27 percent, or 2 additional basis points of interest. In the third auction, for longer deposits, banks received 0.31 percent, or 6 additional basis points of interest. A basis point is 0.01 percentage point. Banks receive 0.25 percent interest on reserves.

The Fed has also tested the reverse repurchase agreements it intends to use as part of its so-called exit strategy from its unprecedented expansionary monetary policy. In a reverse repo, the Fed lends securities for a set period. At maturity, the securities are returned to the Fed, and the cash to the primary dealers. The Fed conducted five trials of this system in December.

“The use of reverse repos and the deposit facility would together allow the Federal Reserve to drain hundreds of billions of dollars of reserves from the banking system quite quickly, should it choose to do so,” Bernanke told Congress in March.

At its last meeting, the Fed backed away from one component of its exit strategy: allowing mortgage-backed securities to roll off the central bank’s balance sheet without being replaced. The Fed instead established a $2.05 trillion floor for its holdings of securities and said it would purchase Treasury securities to replace maturing housing debt.

To contact the reporter on this story: Joshua Zumbrun in Washington at jzumbrun@bloomberg.net.

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