Aug. 21 (Bloomberg) -- Federal Reserve policy makers were briefed last month on the potential for establishing an additional tool to aid them when they eventually seek to lift interest rates and tighten monetary policy.
Fed staff members presented officials the possibility of “a fixed-rate, full-allotment overnight reverse repurchase agreement facility as an additional tool for managing money market interest rates,” according to the record of the Federal Open Market Committee’s July 30-31 gathering released today.
Such a system would allow the FOMC to offer an overnight, risk-free instrument to a “wide range of market participants,” and possibly improve its ability to keep short-term rates at desired levels, the minutes showed.
“The Fed is likely worried that they won’t be able to reduce the amount of excess reserves that they have by only using the facilities that they presently have,” said Ira Jersey, an interest-rate strategist at Credit Suisse Group AG in New York, one of the 21 primary dealers that serve as counterparties to the Fed in open-market operations. “That is particularly true given the new regulatory environment for banks and dealers and how big financial balance sheets can be. The Fed needs to increase its ability to transform its excess reserves into another type of liability.”
Regulations aimed at reducing the risk of another financial crisis and the Fed’s purchase of Treasuries since 2009 have combined to reduce the size of the repo market, where banks and investors borrow and lend Treasuries and other fixed-income securities. The Volcker rule ban on proprietary trading as part of the Dodd-Frank Act to risk-weighted asset requirements under Basel III guidelines and new supplementary leverage ratios have contributed to a contraction in the repo markets in recent years.
The average daily amount of securities outstanding in the U.S. repurchase, or repo, market was $2.6 trillion last month, down 40 percent from $4.3 trillion daily repos outstanding in the first quarter of 2008, according to Fed data of its 21 primary dealers.
Fed policy makers, while still buying bonds to support the economy, have also over the last few years been developing methods to eventually tighten monetary policy. Along with raising the overnight bank lending rate, Fed officials have said they may use tools including reverse repos to withdraw or neutralize cash in the banking system.
The Fed has been conducting tri-party reverse repurchase agreements this month with primary dealers and its expanded list of counterparties including money market mutual funds. The transactions, part of a series of open-market operations first announced in December 2009, don’t represent any change in monetary policy.
Yesterday the Fed drained $5 billion in cash from the banking system through reverse repos for Treasury collateral as part of these tests. The Fed has been expanding its reverse repo counterparties over the last few years given reduced dealer balance sheets, as banks worked to shore up balance sheets after the financial crisis.
The Fed has said these tri-party reverse repos are just a way for the central bank to work on “operational aspects” for the eventual withdrawal of monetary stimulus.
The Fed uses repos and reverse repos to help maintain the level of money in the banking system to keep overnight interest rates close to the central bank’s target. The Fed has held its target rate for overnight loans between banks in a range of zero to 0.25 percent since December 2008.
In a reverse repo, the Fed lends securities for a set period, temporarily draining cash from the banking system. At maturity, the securities are returned to the Fed, and the cash to its counterparties.
In a tri-party arrangement, a third party functions as the agent for the transaction and holds the security as collateral. JPMorgan Chase & Co. and Bank of New York Mellon Corp. are the only banks that serve in a trade-clearing capacity in the tri-party repo market.
The central bank’s large-scale asset purchases, known as quantitative easing, have swelled its balance sheet to more than $3.6 trillion, as policy makers have sought to reduce borrowing costs and stimulate growth.
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