FED FOCUS-Fed wants yet another tool in its swelled policy kit
* U.S. central bank eyes rate-rise on the horizon
* Reverse repo facility could help drain flood of reserves
* Getting 'all their ducks in a row' before tightening
NEW YORK/WASHINGTON, Sept 8 (Reuters) - The Federal Reserve is developing yet another tool to help it keep borrowing costs on target when the era of zero-interest rates eventually ends, suggesting policymakers may doubt their existing ways and means can handle the task on their own.
The newfangled tool is designed to mop up excess cash in the financial system, which if left unchecked could keep rates lower than perhaps desired by the Fed at a later date. If successful, it could smooth what may be a rocky transition to tighter monetary policy when the U.S. central bank finally decides the economy is strong enough to withstand higher interest rates.
The Fed is not about to raise rates any time soon. But it is widely expected to take a first step toward the end of the easy-money era later this month by reducing the amount of cash it injects into the financial system each month through $85 billion of bond purchases.
Years of pumping so much money into the market has left it awash in bank reserves, an unprecedented situation that has sowed concern that a policy turn will not be so easy and could distort key money markets.
"Efforts to restore the fed funds rate as a policy target in the face of these potential market distortions might be less than fruitful," Barclays money market strategist Joseph Abate said in a recent research note.
Talk of the new tool surfaced in minutes of the Fed's last policy meeting in late July, with little explanation beyond a general agreement among top officials that a so-called "fixed-rate, full-allotment overnight reverse repurchase agreement facility" could prove to be helpful.
In such a deal, the Fed trades some of the bonds in its massive $3.6 trillion inventory for cash, allowing it to take money out of the banking and money market system. As an incentive it pays a small amount of overnight interest.
LATEST IN GROWING TOOL KIT
If adopted, the facility would be the latest financial innovation the Fed has floated or used to push the borders of monetary policy in the post-crisis era.
The central bank already possesses the ability to pay interest on the excess reserves that banks park at the Fed overnight. Fed Chairman Ben Bernanke and others have touted their control over this rate as pivotal to their ability to return to more normal times.
"We can raise interest rates even without reducing our balance sheet, by raising the interest rate we pay on excess reserves, which will in turn translate into higher interest rates in money markets," Bernanke told lawmakers earlier this year.
The problem is this tool only applies to banks, leaving other major players in U.S. short-term money markets, such as Fannie Mae and Freddie Mac, the bailed-out government-sponsored giant mortgage companies, and large money market funds, to lend at rates below those offered by the Fed. Money market funds account for about 35 percent of the repurchase, or repo, market, a key short-term funding market.
Large gaps between the interest on excess reserves rate available to banks, currently set at 0.25 percent, and the fed funds effective rate available to the wider money market, recently less than 0.10 percent, have reinforced the idea that the central bank may have less control over its target than it previously believed.
ENTER THE REVERSE REPO
Reverse repos are not new. The Fed conducts them to drain reserves in the normal process of reserve management.
What would be new here is that as a "full allotment" facility, the Fed would take all of the cash offered to it, rather than just a portion.
Also, it would trade with a wider number of counterparties, not just banks, thus plugging the gap in the interest on excess reserves facility.
And the interest rate the Fed would pay would be fixed, rather than an auctioned rate that it might not be able to control. While it could be tied to the target rate set by the bank eight times each year, it could be at any rate the Fed found suitable at the time.
Taken all together, it means the reverse repo rate could be the defacto floor for official borrowing costs, potentially relegating the benchmark fed funds rate to a purely symbolic role. The rate ideally would also narrow any unwanted gaps between the interest on excess reserves rate for the primary dealers and the repo rate for the far broader pool of money funds.
The Fed now does reverse repos with some 139 banks, money funds and government sponsored enterprises such as Fannie and Freddie.
Still, absent a permanent lending window at the Fed for nonbanks, it is unclear whether repo rates will rise as policymakers intend when they raise the interest on excess reserves and the federal funds rate.
"Market illiquidity issues become apparent when the Fed drains from the system," said Steve Blitz, chief economist at ITG Investment Management.
"Through quantitative easing they created a lot of one-way positions with a good lot of them likely to reverse once QE is officially over and there aren't enough Treasuries to meet demand should a real problem unfold and markets seize up," he said.
"So they are trying to get all their ducks in a row if and when the when the day comes - and it usually does when least expected."
(Reporting by Jonathan Spicer and Pedro da Costa; Editing by Dan Burns and Maureen Bavdek)