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Tags: Fed | debate | tightening | tool

Fed Resolves Roller-coaster Debate over New Tightening Tool

Wednesday, 17 September 2014 05:58 PM EDT

The Federal Reserve said on Wednesday a tool for controlling interest rates it had been discussing for some time would be used only temporarily, allowing the central bank to move on to formulate a broader strategy for normalizing monetary policy.

Fed officials emerged from a two-day meeting to unveil an updated blueprint for gradually tightening their ultra-loose policy and shrink the U.S. central bank's swollen balance sheet.

Much of the new "exit principles" document made clear that the so-called overnight reverse repurchase facility, known as RRP, would now take a backseat to two other more familiar policy rates when the time comes to lift borrowing costs.

The central bank will use the RRP tool "only to the extent necessary and will phase it out when it is no longer needed to help control the federal funds rate," the Fed's policy-setting committee said separately from its formal policy statement.

Many Fed officials, economists and financial market participants once believed the repo tool, which has been tested for a year, would become the main lever for steering interest rates and play a central role in a new monetary policy framework.

However, after a long debate over the merits and potential risks of the new tool the Fed decided on a compromise in which the RRP will only supplement the key federal funds rate and the rate the Fed pays banks on their excess reserves.

The reverse repo tool has often been used by other central banks, but is new for the Fed in such an unlimited capacity.

Using this tool, the central bank offers Treasury securities in exchange for cash from banks, money market funds and mortgage finance agencies, effectively paying them to park funds with the Fed.

Officials at the Fed's influential New York branch had big plans for the new RRP facility which was designed to help drain the vast pool of reserves the central bank has created to try to revive the economy in the wake of the 2008 global financial crisis.

But other policymakers had reservations about using the new tool as part of the strategy to tighten monetary policy.

Traditionally, the Fed does business only with a select group of banks, so the broad range of institutions involved in using the new tool raised concerns about markt stability among central bankers.

Minutes from previous meetings showed Fed officials were close to agreeing on the exit principles, which they wanted to publish long before they start raising interest rates. The compromise on the new tool likely paved the way for the plan to be announced on Wednesday.


As the New York Fed ramped up testing of the overnight reverse repo tool late last year, financial market players started preparing for a major new Fed presence in short-term funding markets.

In December, Simon Potter, head of markets at the New York Fed, said the tool's users were telling his team it would effectively control money market rates "if executed in full scale in the future."

"When it first came through everyone thought it would be integral to monetary policy," said Gennadiy Goldberg, a strategist at TD Securities.

But in January the Fed's policy-setting committee decided that its chair, Ben Bernanke at the time, would approve any subsequent changes to the new rate during the testing, an apparent effort to wrest some control of the facility from the central bank's New York branch.

Later in March, just a few blocks from the New York Fed's headquarters, Philadelphia Fed President Charles Plosser told an audience of bond traders that the Federal Open Market Committee, and not the New York Fed's open markets desk, would ultimately decide its fate.

How to drain more than $3 trillion of funds pumped into the economy since 2008 without causing market upheaval and hurting the economic recovery is the ultimate challenge for the Fed.

The new facility has been a key topic in policy-setting committee meetings since April. One chief worry has been that giving money market funds unlimited access to the new facility could spark "runs" from more risky assets in times of financial stress.

By July, most officials appeared to agree that reliance on the tool should be limited and temporary, a notion that was formalized on Wednesday.

According to the new principles, the key policy rate will remain the rate on overnight lending between banks known as the fed funds rate. The Fed intends to move that rate into its target range "primarily" by adjusting the interest on excess reserves rate, or IOER. The repo rate will only be used "as needed," they said.

Minutes from the last Fed meeting show the fed funds rate would be pinned within a quarter percentage point corridor, with the excess-reserves rate serving as the ceiling, and the reverse repo rate acting as a floor.

"The FOMC's intention has always been to return to a more traditional approach," Fed chair Janet Yellen told reporters after the meeting.

"I'd like to emphasize that the overnight RRP facility will only be used to the extent necessary and will be phased out when no longer needed to control the federal funds rate," she said.

© 2023 Thomson/Reuters. All rights reserved.

The Federal Reserve said on Wednesday a tool for controlling interest rates it had been discussing for some time would be used only temporarily, allowing the central bank to move on to formulate a broader strategy for normalizing monetary policy.
Fed, debate, tightening, tool
Wednesday, 17 September 2014 05:58 PM
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