Wall Street sees holes in Fed's new policy-tightening plan

Wall Street sees holes in Fed's new policy-tightening plan
| Reuters

For a year, the central bank has been testing the facility as a way to control short-term rates by draining the trillions of dollars in reserves it has created fighting the deep recession. It has seen strong demand from bidders. But Fed policymakers grew concerned that over-reliance on repos could encourage runs on some funds deemed risky in times of market stress, and wanted to limit use of the facility.
"The new operating system has sacrificed control in favor of minimizing the Fed's presence in the repo market for fear a large presence may cause distortions," said William Lee, head of North America economics at Citigroup, adding the decision "may be a mistake."
The Fed, however, left itself much wiggle room. The new repo limits can be changed or dropped; no date was set for termination of the facility; and the central bank said it is "prepared to adjust the details" of its normalization plan based on economic or financial developments.
The Fed aims to use the repo rate as a floor when it raises the overnight federal funds rate to a higher target range, say between 0.25 and 0.50 percent. A rate the Fed pays banks on their excess reserves would serve as the ceiling and, according to the plan, be the primary tool to tighten policy.
Given the desire to limit use of repos, Fed Chair Janet Yellen acknowledged on Wednesday that the key fed funds rate "may vary within the target range and could even move outside of that range on occasion, but such movements should have no material effect on financial conditions or the broader economy."
Once demand at the facility exceeds $300 billion, an auction will determine the repo rate, not the central bank. In this case, investors would look beyond the Fed to other sources for funding, and the market-based rate would decline.
"In effect, this could mean a soggy or softer floor for the (fed funds) corridor," Millan Mulraine, deputy head of U.S. research at TD Securities, wrote in a client note.
"When the Fed goes live next year they are almost certainly expected to revert back to setting the price, and having the market determine the quantity of excess reserves drained," he wrote. "Otherwise it will work against the purpose of tightening."