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UPDATE 1-Key U.S. interest rate breaks critical level before Fed move

Richard Leong

(Recasts lead with context; adds analyst comment, background)

NEW YORK, March 21 (Reuters) - The U.S. Federal Reserve's key interest rate broke above a critical level for the first time on Wednesday, according to newly released data, which may raise alarm about the central bank's effectiveness in controlling short-term rates if the rate increases further.

The rise in the average cost for U.S. banks to borrow excess reserves from each other overnight, known as federal funds, above what the Fed pays on excess reserves came on the same day that Fed policy makers put forth a plan to halt the shrinkage of the U.S. central bank's bond holdings. Some traders have blamed the shrinkage in the Fed's bond holdings for recent turbulence in money markets.

The New York Federal Reserve Bank released the data on the borrowing rate on Thursday.

The average, or "effective," federal funds rate came in at 2.41 percent on Wednesday, above the 2.40 percent interest rate the U.S. central bank currently pays on the excess reserves that banks (IOER) leave with it.

In 2018, the Fed adjusted the IOER twice in an effort to keep the effective fed funds rate in the middle of its target range, which is currently at 2.25 percent to 2.50 percent.

Wednesday's rise in the fed funds rate also fueled speculation that the Fed may target another overnight rate as the daily activity in the fed funds market has dwindled over the past decade.

Some traders and analysts have blamed the Fed's balance sheet normalization for a decline in excess reserves for banks to trade in the fed funds market.

In December, the shortage of excess reserves was so acute that it sent borrowing costs soaring in other parts of money markets that Wall Street relies on to fund its trades.

"That's telling the Fed to end its portfolio run-off sooner," said Gennadiy Goldberg, senior interest rate strategist at TD Securities in New York.

Banks' bidding for excess reserves at month-end and quarter-end to meet regulatory rules has only exacerbated this perceived imbalance, analysts said.

On Wednesday, the Fed, following a two-day policy meeting, said that as of May it would slow its monthly reduction of as much as $50 billion in bond holdings, and stop them altogether in September.

"They do recognize this scarcity issue," said Gemma Wright-Casparius, senior portfolio manager at Vanguard in Malvern, Pennsylvania. "The Fed's objective with its balance sheet is 'do no harm."'

(Reporting by Richard Leong Editing by Chizu Nomiyama and Leslie Adler)