Armed with new tools, Fed aims to avoid bumpy rates lift-off4 min read . Updated: 11 Dec 2015, 03:55 PM IST
Fed's market specialists are still not sure how smoothly they will be able to lift interest rates after 7 years at zero
New York: After more than two years of daily testing and regular meetings with Wall Street traders and investors, the Federal Reserve’s market specialists are still not sure how smoothly they will be able to lift interest rates after seven years at zero.
The US central bank is expected to raise its policy rates by a quarter of a percentage point next Wednesday, but only the next morning its markets team will know how effective the Fed’s new and lightly-tested tools will be in prying rates off the floor.
A worst-case scenario for the Fed would be if market rates refused to budge or edged up far less than desired though both the Fed and markets expect the tools to work fine.
The task will be far trickier than before the 2008 financial crisis when the Fed ensured rates hit its desired target by trading securities with 22 primary dealers and thus controlling money market liquidity.
Now, after years of monetary stimulus and zero borrowing costs, all banks are flush with $2.6 trillion in additional reserves, so the central bank can only lead market rates towards its increased target by trying to soak up excess cash.
It will need to do that by paying banks interest on extra cash parked with the Fed. The central bank will also let about 130 money funds place funds with it and earn interest via an overnight reverse repurchase market designed to mop up extra cash.
A handful of Fed market specialists will orchestrate the action and look for any signs of trouble from the New York Fed’s “operations room" three blocks off Wall Street.
If market rates failed to move much on day one, the Fed’s policy committee could decide right away to expand the repo operation or its board could raise the interest on reserves. If rates were simply volatile, policymakers would probably give market a few days to settle.
A bumpy lift-off could raise doubts about how effectively the Fed can control the short-term rates through which central bankers influence borrowing costs in the economy.
“The Fed doesn’t have as much control as it used to have," said Michael Cloherty, head of Royal Bank of Canada’s US rates strategy.
Fed officials have expressed confidence in the new machinery, but the New York Fed has been reminding Wall Street that the federal funds rate that it targets could bounce around in its new range of 0.25-0.5%. Rates could even temporarily slip out of the range at month- and quarter-ends when demand for safe assets soars, the Fed has warned.
Interviews also show there is deep uncertainty over the behaviour of funds run by Blackrock, Fidelity and other money managers, as well as the 13 government-sponsored enterprises, such as Fannie Mae and Freddie Mac. They will all have access to the reverse repo programme in which the Fed will take in money overnight at the 0.25% “floor" rate.
Too little interest could leave rates below the Fed’s target. Too much could strip the market of liquidity and possibly exacerbate investor runs in the rare instance of panic.
To ensure the programme is not overwhelmed, traders expect the Fed to at least double its current $300-billion cap, with many looking for a $750 billion ceiling. To play it safe the Fed might even push the limit to $1 trillion or ditch it altogether, Fed officials and market participants say.
Such a “full force" operation would help reduce volatility, but the bigger the scale the harder it might be to roll back what has been designed as a temporary program, possibly keeping it intact through next year or even beyond.
JPMorgan predicted that daily demand for the Fed’s reverse repo programme could surge six-fold from roughly $110 billion now, with money funds, starved of safe interest-earning opportunities, accounting for most of the increase.
Fed’s markets team led by Simon Potter will run the repo auction on a 10-year old programme called FedTrade, into which banks and funds plug on computers across the country, and will be the first to know if the lift-off went without a hitch.
Potter and his deputies have held planning sessions with bankers all year. To minimize the risk from natural disasters or technical outages, the New York Fed has also bulked up a satellite office in Chicago where backup traders will be stationed.
If the Fed raises its policy rates next Wednesday, then the following morning its traders will monitor the fed funds, Eurodollar and other short-term rates to make sure they move along with the rate on excess bank reserves.
They will also make what they call “sanity checks" on the bids to limit the risk of an erroneous entry wreaking havoc and if needed make follow-up calls to the banks and funds which placed them.
Even if the initial lift-off goes smoothly, the repo facility will face another big test at the year-end auction on 31 December, which is expected to attract huge demand because banks trim regular lending to shore up year-end balance sheets. Reuters