Fed reviews fixed-rate reverse repo facility as aid to exit

Federal Reserve policy makers were briefed last month on the potential for establishing an additional tool to aid them when they eventually seek to lift interest rates and tighten monetary policy.

Fed staff members presented officials the possibility of “a fixed-rate, full-allotment overnight reverse repurchase agreement facility as an additional tool for managing money market interest rates,” according to the record of the Federal Open Market Committee’s July 30-31 gathering released today.

Such a system would allow the FOMC to offer an overnight, risk-free instrument to a “wide range of market participants,” and possibly improve its ability to keep short-term rates at desired levels, the minutes showed.

“The Fed is likely worried that they won’t be able to reduce the amount of excess reserves that they have by only using the facilities that they presently have,” said Ira Jersey, an interest-rate strategist at Credit Suisse Group AG in New York, one of the 21 primary dealers that serve as counterparties to the Fed in open-market operations. “That is particularly true given the new regulatory environment for banks and dealers and how big financial balance sheets can be. The Fed needs to increase its ability to transform its excess reserves into another type of liability.”

Regulations aimed at reducing the risk of another financial crisis and the Fed’s purchase of Treasuries since 2009 have combined to reduce the size of the repo market, where banks and investors borrow and lend Treasuries and other fixed-income securities. The Volcker rule ban on proprietary trading as part of the Dodd-Frank Act to risk-weighted asset requirements under Basel III guidelines and new supplementary leverage ratios have contributed to a contraction in the repo markets in recent years.

Shrinking Market

The average daily amount of securities outstanding in the U.S. repurchase, or repo, market was $2.6 trillion last month, down 40% from $4.3 trillion daily repos outstanding in the first quarter of 2008, according to Fed data of its 21 primary dealers.

Fed policy makers, while still buying bonds to support the economy, have also over the last few years been developing methods to eventually tighten monetary policy. Along with raising the overnight bank lending rate, Fed officials have said they may use tools including reverse repos to withdraw or neutralize cash in the banking system.

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