Fed may need to act if supply fall stresses rates

By Karen Brettell

NEW YORK (Reuters) – An already acute shortage of short-term U.S. government debt could worsen, putting the Federal Reserve in a tight spot if short-term money rates fall further.

The federal funds rate is hovering near five-month lows after a new fee by the Federal Deposit Insurance Corp led some banks to exit the market and in turn dried up the availability of collateral backing short-term loans.

Analysts at Credit Suisse think the rate, which is the cost of overnight bank loans and can impact borrowing costs across the economy, could fall further as the supply of short-term debt this month could decline by around $150 billion.

That would force borrowing rates lower at a time when some at the Federal Reserve think the cost of money should rise as the economy shows signs of a sustained recovery.

As a result it would force the Fed into the uncomfortable position of appearing to tighten policy long before an exit from its current easy-money mode is expected.

The decline in rates could force the Fed to act to ease the shortage of short-term debt to stabilize short-term lending markets, some analysts say. Doing so risks sending a misleading signal to already nervous markets that it is ready to tighten policy.

“The most effective tool the Fed could employ in order to put upward pressure on general collateral and fed funds would be reverse repos, though doing so would present a communication challenge,” said Credit Suisse analyst Scott Sherman.

Reverse repos, where the Fed offers out Treasury bill collateral to banks in exchange for loans, are typically a sign that a central bank is tightening policy. Fed Chairman Ben Bernanke has suggested the Fed could use reverse repos along with other tools once it is time to tighten policy, even as he has lately given no hint that he thinks the time to do so is near.

Rumors that the Fed was planning to execute a program earlier this week hurt Treasuries in the broader market as investors feared it would then lead to an interest rate hike.

“Most things that are construed as tightening are going to impact the belly and the front end, depending on how quickly people view this as a precursor to an actual hike,” said Keith Blackwell, interest rate strategist at RBC Capital Markets.

Though low, at 0.09 percent, fed funds rates remain in the Fed’s target for overnight bank lending to between zero and 0.25 percent since December 2008, meaning the Fed should have no problem conducting its policies, said Todd Colvin, a vice president at MF Global in Chicago.

“As long as it’s still within the range, the Fed’s probably comfortable with that,” he said.

An impending drop in supply, however, could send rates still lower and force the Fed to rethink its strategy.

This may be especially the case as the central bank has previously relied on bank borrowing in the fed funds market, and some banks are said to be no longer active and may be unlikely to return.

“The Fed has relied on insured banks to intermediate in the fed funds market in order to prevent fed funds from trading too far below the interest on excess reserves (IOER) rate,” said Sherman. “By essentially taxing this intermediation, the FDIC has unintentionally impaired the efficacy of IOER as a policy tool to control the funds rate.”

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SUPPLY SHORTAGE MAY WORSEN

The FDIC’s rule came at an inopportune time when it was introduced on Friday, as supply of short-dated debt was already low. It is also likely to worsen in the coming weeks.

A $200 billion program that allowed the government to issue short-term debt has rolled off in recent weeks and the government cannot implement a new program until its debt ceiling is raised, which is not expected until at least next month.

Meanwhile sales from the government’s traditional calendar will decline after the tax deadline on April 15, as the Treasury typically front-loads sales to pay for tax refunds, with issuance then declining through the rest of the month.

“All else equal, (it) should put additional downward pressure on general collateral and short-dated bill yields,” Sherman said.

(Additional reporting by Ann Saphir in Chicago; Editing by James Dalgleish)

Fed may need to act if supply fall stresses rates