FACTBOX-Fed’s exit strategy toolkit

April 30 (BestGrowthStock) – The U.S. Federal Reserve on Friday
took steps towards creating tools that could help it eventually
withdraw the billions of dollars it pumped into the economy to
combat recession and the global financial crisis.

The Fed’s Board of Governors said in a statement it had
authorized a term deposit facility, similar to certificates of
deposits banks offer their customers, that could be used by the
Fed to lock up excess cash. The New York Fed, for its part,
posted a contract in a step towards testing reverse repurchase
agreements with money market funds.

Below are tools the Fed could use when it decides the time
has come to tighten policy.

PAYING INTEREST ON EXCESS RESERVES

The interest rate the Fed pays on excess reserves will be
the one to watch once the Fed — the U.S. central bank —
begins to raise borrowing costs.

By raising the rate it pays on bank reserves, the Fed
creates a magnet for banks to keep those reserves with the Fed
rather than lend them out.

“By increasing the interest rate on reserves, the Federal
Reserve will be able to put significant upward pressure on all
short-term interest rates, as banks will not supply short-term
funds to the money markets at rates significantly below what
they can earn by holding reserves at the Federal Reserve
Banks,” Fed Chairman Ben Bernanke told lawmakers on March 25.

A number of central banks around the world have effectively
used similar tools.

LARGE-SCALE REVERSE REPURCHASE AGREEMENTS

The Fed could arrange large-scale reverse repurchase
agreements (reverse repos), with financial market participants.
They would temporarily drain reserves from the banking system
and reduce excess liquidity at other institutions.

Reverse repos involve the sale by the Fed of securities
from its portfolio with an agreement to buy them back at a
slightly higher price at a later date.

The New York Fed’s open market desk last year tested its
ability to conduct term reverse repos with primary dealers —
its usual dealing partners — using agency debt and
Treasuries.

Minutes from the Fed’s January policy meeting showed staff
expect it will be able to conduct reverse repos using
mortgage-backed securities as collateral “early this spring.”

Bernanke has said the Fed has been working to expand its
range of counterparties for reverse repos beyond primary
dealers.

TERM DEPOSIT FACILITY

The Fed has authorized the creation of a new “term deposit
facility” for banks, similar to certificates of deposit that
banks offer retail customers. Like the reverse repos, this
would reduce the supply of funds banks have available to lend
to each other.

While the Fed already pays interest on reserves held
overnight, a term deposit facility would lock up funds for
longer.

“The Federal Reserve would likely auction large blocks of
such deposits, thus converting a portion of depository
institutions’ reserve balances into deposits that could not be
used to meet their very short-term liquidity needs and could
not be counted as reserves,” Bernanke said on Feb. 10.

The Fed said on April 30 that it expects to conduct
small-value offerings of term deposits in coming months to test
the mechanism.

The minutes of the January meeting showed that staff expect
the facility to be operational as soon as May.

ASSET SALES

The Fed could sell a portion of its securities holdings
into the open market.

“The redemption or sale of securities holdings would have
the effect of reducing the size of the Federal Reserve’s
balance sheet as well as further reducing the quantity of
reserves in the banking system,” Bernanke said on March 25.

He said in February he did not anticipate the Fed will sell
any of its security holdings in the near term, at least until
after policy tightening has gotten under way and the economy is
clearly in a sustainable recovery.

Other Fed policymakers hold a more favorable view of sales.
Several think it is important to begin sales in the near future
to ensure the Fed’s balance sheet shrinks more quickly than if
it relied on prepayments and redemptions of maturing
securities.

DISCOUNT RATE INCREASE

The Fed in February raised the discount rate — the rate it
charges banks for emergency loans — to 0.75 percent from 0.5
percent. It stressed the move reflected healing financial
markets and was not a step to tighten lending conditions.

The Fed has said it is studying whether further increases
in the spread between the discount rate and the federal funds
rate would be appropriate.

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FACTBOX-Fed’s exit strategy toolkit