US Fed has ‘tools’ for smooth rates lift-off

April 16, 2015

Washington (Apr 16)  A senior Federal Reserve official has expressed confidence that new levers being prepared by the US central bank to raise interest rates will work when needed — while acknowledging differences between senior officials over some key details.

Extensive testing by the New York Fed has made policy makers confident that they have the "necessary tools to enable a smooth lift-off", said Simon Potter, executive vice-president of the Federal Reserve Bank of New York. However, he said the central bank would have to be flexible in adapting the levers it is pulling as it learns more about market responses.

The Federal Reserve Building in Washington, D.C.

The Fed is having to prepare new mechanisms to set rates when it starts hiking because quantitative easing has flooded the system with reserves. Traders have been raising questions about the details of the new facilities, in part because of disagreements which emerged in minutes of the Fed's latest policy meeting.

The central bank has said it will use two interest rates to set the ceiling and floor of its target range when it starts lifting rates from near-zero levels that have prevailed since 2008. The interest rate the Fed pays on banks' excess reserves will be used to set the upper end of the range, while the floor will be established through a new "overnight reverse repo programme" — or ON RRP.

This latter tool is targeted at non-banks such as money-market funds, and it has been subject to a lengthy programme of testing. Some players say that the ON RRP will have to be very large in order to act as an effective floor on interest rates, and Fed officials in their latest meeting agreed that they might temporarily allow a higher limit on the facility early on as rates rise.

Mr Potter acknowledged that officials disagree over how much the ON RRP will need to be used, and how it can be phased out. However, he added: "All agree that demonstrating sufficient control over money market rates during the critical early stages of policy normalisation is a priority."

He said the need to demonstrate full control over rates when the Fed is first lifting them could mean there was a need for an "elevated aggregate capacity" in the facility at lift-off. This was because the Fed was not sure how much support was being given to rates simply because monetary policy is currently operating at near-zero levels.

However, he said that there was a natural "glide path" for the ON RRP facility to be phased out over time as the Fed's balance sheet reduces. The level of reserves is projected to fall below $1tn in early 2019 and to reach its steady state in late 2020, he added.

"The ON RRP will be used only to the extent necessary for monetary policy control because it has some potential financial stability and footprint costs associated with it," Mr Potter said.

The Fed was ready to deploy a number of mechanisms to "discourage usage and shrink the footprint of the facility". He added: "Flexibility is a critical element of the Federal Reserve's approach to policy normalisation."

Source: CNBC

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