No sooner did the Federal Reserve reveal its plan for
eventually tightening U.S. monetary policy than many on Wall Street flagged
problems with the mechanics of the strategy, and said more adjustments would
have to come. Some market participants worried that a new limit on the Fed's
reverse repurchase facility would hurt efforts to raise interest rates as
quarters draw to an end when investors typically hunt for collateral. Others
predicted the controversial tool would ultimately play a bigger role than the
U.S. central bank let on. In reverse repos, the Fed offers Treasury securities
as collateral in exchange for cash from banks, large money market mutual
funds and others, temporarily draining cash from the financial system.
On Wednesday, the Fed surprised many by updating its policy
"normalization" plan, meant to help the public understand exactly how
it will raise rates from near zero when the time comes. The process will be
unusually tricky given the tremendous amount of liquidity the central bank has
pumped into financial markets to try to spur a stronger economic
recovery.
The Fed also issued a policy statement at the close of a
two-day meeting that suggested the first rate hike wasn't due until around the
middle of next year.
According to the plan, the overnight repo facility, or RRP,
would only be "supplementary," used "as needed" to serve as
an effective floor under the main federal funds rate, and later shuttered. At
the same time, the Fed tripled the amount that each bank or fund could lend
into the facility during its current testing and applied an overall
$300-billion cap, less than the $340 billion in demand RRP faced at the
quarter-end on June 30.
The new cap on what had been an unlimited facility raised
fears that once the tightening cycle begins, and demand rises, financial markets could
face unusual volatility on days that firms scramble for short-term collateral. The
new limits are effective Sept. 22, and analysts said volatility could erupt
eight days later when the quarter draws to a close. Some noted that the Fed
aims to gather information on how participants will react on Sept. 30.
For a year, the central bank has been testing the facility
as a way to control short-term rates by draining the trillions of dollars in
reserves it has created fighting the deep recession. It has seen strong demand
from bidders. But Fed policymakers grew concerned that over-reliance on repos
could encourage runs on some funds deemed risky in times of market stress, and
wanted to limit use of the facility.
The Fed, however, left itself much wiggle room. The new repo
limits can be changed or dropped; no date was set for termination of the
facility; and the central bank said it is "prepared to adjust the
details" of its normalization plan based on economic or financial
developments.
The Fed aims to use the repo rate as a floor when it raises
the overnight federal funds rate to a higher target range, say between 0.25 and
0.50 percent. A rate the Fed pays banks on their excess reserves would
serve as the ceiling and, according to the plan, be the primary tool to tighten
policy.
Once demand at the facility exceeds $300 billion, an auction
will determine the repo rate, not the central bank. In this case, investors
would look beyond the Fed to other sources for funding, and the market-based
rate would decline.
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