Dec. 3 (Bloomberg) -- Simon Potter, the Federal Reserve Bank of New York’s markets group chief, said the Fed’s new reverse repurchase agreement tool probably will be a key part of how the central bank eventually tightens monetary policy.
Market “participants have indicated that they expect that a facility, if executed in full scale in the future, should be an effective tool for increasing the Federal Reserve’s control of short-term money market rates,” Potter said yesterday in a speech in New York. He is in charge of the System Open Market Account used in implementing monetary policy.
Fed officials have been testing the new tool -- known as a fixed-rate, full allotment overnight reverse repo facility -- aimed at improving their control of near-term borrowing costs when they tighten policy by siphoning off excess cash in the banking system.
“Operationally, market participants generally characterize the exercise as smooth, with minimal disruptions,” Potter said.
The program would allow banks, broker-dealers, money-market funds and some government-sponsored enterprises to lend the Fed unlimited amounts of cash overnight at a fixed rate, currently 0.05 percent, in exchange for borrowing Treasuries in so-called reverse repo transactions.
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.
Used along with the Fed’s ability to pay interest on excess reserves, the repo facility “may strengthen the floor for short-term interest rates and, with it, the Federal Reserve’s control of money market rates, by surmounting the competitive and balance sheet frictions seen in money markets and by extending the central bank’s payment of interest to a wider universe of relevant counterparties,” Potter said.
The Fed has been extracting cash from the money markets with the tool since September, which is starting to create a floor for short-term rates.
The operations have helped lift the rate for borrowing and lending Treasuries for one day to an average 0.11 percent as of Nov. 29. That’s up from 0.051 percent the day the program was announced Sept. 20, according to a Deposit Trust & Clearing Corp. General Collateral Finance Treasury Repo Index.
Rates on Treasury bills with very short maturities have risen since September, even with only on average of $6.25 billion a day in the reverse-repo transactions since Sept. 23. One-month Treasury bill rates rose yesterday to 0.0152 percent, from 0.0051 percent on Sept. 20.
“The facility’s value in terms of monetary policy implementation wouldn’t necessarily be determined by the amount of usage,” Potter said. “If the facility increases bargaining power for market participants, it could conceivably provide an effective floor for short-term rates, giving the Desk tighter control of money market conditions even with usage of the facility that’s low on average.”
While the Fed gained the ability in 2008 to pay interest on cash it holds in the form of excess reserves, or IOER, that tool has had limited effectiveness in anchoring borrowing costs because only banks are able to earn such interest.
“The facility is expected to complement IOER, strengthening the floor on the level of overnight rates and tightening the relationship among various money market rates,” Potter said.
“Improved control over the level of money-market rates and reduced volatility of short-term interest rates could enhance the flexibility of the desk’s operational tools, ultimately allowing for a more robust and effective implementation of the” Federal Open Market Committee’s “policy directives both during the rate normalization period and when there is a very large balance sheet,” Potter said.
The central bank is buying $85 billion of bonds each month and its three rounds of asset purchases have expanded its balance sheet to more than $3.9 trillion.
Policy makers are debating ways to offset a potential jump in interest rates when they decide to taper the pace of their bond buying, the minutes from the FOMC’s October meeting show. They discussed whether to cut the interest paid on reserves, the minutes said.
Potter said in response to audience questions after his speech that the option has “been around” for a while and has a “well-known” risk of damaging money-market functioning.
“That con is definitely still there,” Potter said. The positive effect would be to “get a small drop” in borrowing costs.
To contact the reporter on this story: Caroline Salas Gage in New York at email@example.com