Fed Moves Closer to Choosing Main Stimulus-Exit Tool

Federal Reserve officials moved closer to deciding on the main tool they will use to tighten monetary policy when the time comes, most likely next year.

Most participants at the Federal Open Market Committee’s June meeting agreed that the interest rate on excess reserves banks keep on deposit at the Fed “should play a central role” in the exit from extraordinary monetary stimulus, according to minutes released today in Washington.

Another tool, known as the overnight reverse repurchase facility, “could play a useful supporting role,” according to the minutes. The tool could be used to set the lowest rate at which holders of cash would be willing to lend.

The Fed now pays 0.25 percent interest on bank reserves deposited overnight at the central bank. By contrast, it pays 0.05 percent on cash it borrows through its reverse repo facility, which is used by institutions such as money-market funds, which can’t deposit money at the Fed.

Many members of the FOMC judged at the June meeting that “a relatively wide spread -- perhaps near or above the current level of 20 basis points -- would support trading in the federal funds market and provide adequate control over interest rates,” according to the minutes.

A narrower spread between the two rates would give the reverse repo facility a bigger role by increasing incentives for depositors to pull cash out of banks and put it in money-market funds in search of higher interest.

Dudley Speech

In a May 20 speech, Federal Reserve Bank of New York President William C. Dudley warned that if the two rates “were set very close or equal,” the result could be “a large amount of dis-intermediation out of banks through money-market funds and other financial intermediaries” into the reverse repurchase facility. He added that this “could encourage further development of the shadow banking system,” which isn’t regulated by the Fed.

The minutes of the June FOMC meeting echoed this concern, with a number of officials noting that heavy use of the reverse repurchase facility “had the potential to expand the Federal Reserve’s role in financial intermediation and reshape the financial industry in ways that were difficult to anticipate.”

Most participants at the meeting also agreed that the federal funds rate “should continue to play a role in the Committee’s operating framework and communications during normalization, with many of them indicating a preference for continuing to announce a target range.”

If the reverse repurchase rate were moved too close to the interest rate on excess reserves, “a lot of fed funds activity would just disappear,” said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey.

The central bank’s main rate, the federal funds rate, has been held near zero since December 2008. It represents the cost of overnight money in the interbank market.

Before it's here, it's on the Bloomberg Terminal.