Federal Reserve prepares toolkit for higher rates

For the Federal Reserve, deciding the date of its first interest rate rise is only part of the battle. As the US central bank prepares for the first increase in nearly a decade, a debate is still under way over new levers it will use to transmit its decisions into the broad reaches of the financial markets.

Observers say details are still to be clarified amid signs of disagreement over a new rate-steering tool that has provoked financial stability concerns on the Federal Open Market Committee. Additional questions need to be resolved as hundreds of billions of dollars of treasuries in the Fed's portfolio start maturing next year.

Ben Bernanke, the Fed's former chairman, this month muddied the waters further by publicly querying the central bank's entire approach to exit, suggesting it was aiming to reduce its $4.5 trillion balance sheet too far.

Brian Smedley, rates strategist at Bank of America Merrill Lynch, says there was "tremendous uncertainty" about what will be needed when the Fed moves away from zero rates. "I don't have much doubt that they can pull it off, but it will probably be a bumpy road and we will all be learning as we go along," he said.

The Fed has radically overhauled its monetary toolkit as it responds to a very different financial scene to the one prevailing when it last raised rates in 2006. New levers are necessary in part because of the creation of trillions of dollars of extra reserves through quantitative easing, which makes it hard for the Fed to use its traditional tool of varying the supply of reserves to steer rates.

The central bank is planning to use the interest rate it pays on excess reserves parked at the central bank supplemented by a so-called overnight reverse repo facility (RRP) to manage its key fed funds rate - as well as keeping other levers in the wings.

The RRP has been set up under the control of the Federal Reserve Bank of New York's markets desk. It will pull cash from the financial system via short-term loans of Treasuries from the Fed's balance sheet to a wide array of players including money market funds, extending the Fed's influence beyond ordinary banks.

The central bank has been testing this financial plumbing for a year and a half, but how stable it will keep rates around the Fed's overnight benchmark on lift-off is yet to be seen. FOMC members have disagreed over how much the RRP should be used and how to phase it out, amid concerns that it will distort the financial system and become a flight haven in a crisis.

While the FOMC said at its March meeting it would allow a "temporarily elevated" capacity for the RRP, this would only be for a short period, which makes some players uneasy. Fed officials further complicated the picture by discussing the prospect of selling short-term assets to pull down the usage of the facility.

Mr Bernanke waded into the debate on April 15, claiming that the FOMC's entire approach to winding down its balance sheet and the RRP might be misguided, calling for further debate. "I wonder if the case for keeping the balance sheet somewhat larger than before the crisis has been adequately explored," he said at a conference arranged by the International Monetary Fund.

The Fed also faces the looming runoff of its portfolio of treasuries, which begins early next year. Marc Chandler of Brown Brothers Harriman estimates that there are at least $200bn of treasuries in the Fed's portfolio due to mature in 2016.

Allowing the redemptions to proceed uninterrupted would in itself be a tightening of policy as the Fed balance sheet shrinks sharply. The issue for the Fed is whether to adjust the profile of redemptions - an issue that Dov Zigler of Scotiabank says it needs to clarify within months. Some analysts think it should go further and use asset sales as the primary tool to control rates.

Simon Potter, a top official at the NY Fed, assured traders this month that the central bank would be agile as it reacts to changing market conditions after lift-off. He said officials differed over aspects of exit, but added: "All agree that demonstrating sufficient control over money market rates during the critical early stages of policy normalisation is a priority."

Some analysts say they were reassured by the tone and details of his speech. Lou Crandall, chief economist at Wrightson ICAP, says: "There is no technical reason why the Fed should not be able to manage lift-off fairly smoothly. The question is whether the FOMC will take a flexible enough approach."

© The Financial Times Limited 2015. All rights reserved.
FT and Financial Times are trademarks of the Financial Times Ltd.
Not to be redistributed, copied or modified in any way.
Euro2day.gr is solely responsible for providing this translation and the Financial Times Limited does not accept any liability for the accuracy or quality of the translation