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Oct 8 (Reuters) - The Federal Reserve's plan to start adding to its $3.6 trillion bond portfolio soon is the clearest signal yet that the central bank is looking to deliver long-term solutions to address recent disruptions in key short-term funding markets.
After cutting the Fed's asset holdings by more than $600 billion in the past two years, the time to expand again "is now upon us," Fed Chair Jerome Powell told the National Association for Business Economics convention in Denver on Tuesday.
"It is clear that without a sufficient quantity of reserves in the banking system, even routine increases in funding pressures can lead to outsized movements in money market interest rates," Powell said.
"This volatility can impede the effective implementation of monetary policy, and we are addressing it," he said.
Powell's remarks come on the heels of an announcement on Friday that Fed officials will continue injecting liquidity into cash markets until early November. Those daily operations in the repurchase agreement - or repo market - were scheduled to end this week.
Borrowing rates in the repo market spiked to 10% from about 2.25% in mid-September after larger than expected tax payments and Treasury auctions increased demand for cash.
At that time, the New York Federal Reserve was able to stabilize rates by injecting cash into overnight lending markets through daily repo operations.
But investors, traders and strategists have wanted the Fed to deliver a more permanent fix to help minimize volatility through the end of the year.
"The market wants to be reassured that the Fed stands ready to add liquidity as needed," said Mark Cabana, head of U.S. rates strategy at Bank of America Merrill Lynch.
Fed officials had anticipated that its reserves, which shrunk after the Fed began reducing its balance sheet in the fourth quarter of 2017, would fall short of demand from banks. But they reached that point earlier than expected, in part because regulations have altered the level of reserves banks need to have on hand.
Although Powell did not specify how much they would be adding to the balance sheet, he said he thought the equilibrium level for reserves, which is estimated to have stood at about $1.4 trillion at the time of the September volatility, is close to $1.5 trillion.
Some analysts and strategists say that the right level is between $1.6 trillion and $1.8 trillion.
Bolstering the balance sheet could help the Fed soothe markets through periods of potential stress expected through the end of the year, analysts say, citing a corporate tax deadline in mid-December, Treasury auctions in the fourth quarter and adjustments from banks worried about regulatory requirements.
Demand for the daily repo operations has declined in recent days, suggesting that the Fed may have relieved the "most acute pressure" that existed in the system, Cabana said. Term repo loans, with offerings of up to two weeks, also helped to provide some clarity for investors in need of cash, he said.
Powell said on Tuesday the Fed would continue to conduct temporary repo operations as needed to keep rates under control.
But some analysts believe the central bank should consider the longer-term step of creating a standing repo facility, which would allow financial firms to borrow cash as needed at a fixed rate.
Such a facility could help to prevent a liquidity crunch by reducing the demand for cash reserves, said Joseph Abate, short rates strategist for Barclays.
Some banks are currently holding on to more cash to meet liquidity requirements because they are concerned that Treasury bonds could need to be sold at a loss during a crisis, he said.
If firms knew that they could turn to a standing repo facility at the Fed any time they needed cash, they might feel comfortable holding more Treasuries and less cash, Abate said.
"The idea is that banks currently hold more reserves than they need to," Abate said.
Fed officials discussed creating such a facility in June, but members disagreed over how the program would be structured, which market participants interpreted as meaning it was not likely to happen anytime soon.
Philadelphia Fed president Patrick Harker said last month that the "discussions are in their infancy."
Minutes from the Fed's last meeting, due to be released on Wednesday, could offer more clues into the options officials are leaning toward and how quickly they expect to act.
"Theyre clearly showing a determination to act as needed to stabilize the money market," said Michael Feroli, chief U.S. economist for JPMorgan Chase. "Its an open question as to whether they're going to do a standing repo facility." (Reporting by Jonnelle Marte Editing by Sonya Hepinstall)