May 20, 2014 / 6:07 PM / 3 years ago

Fed's Dudley signals support for reverse repo tool

(Reuters) - New York Federal Reserve President William Dudley on Tuesday offered a big thumbs-up for one of the new tools the Fed may use to control rates when it eventually begins to raise them, and gave a second, even newer tool a decidedly cooler review.

The comments, at the tail end of a major policy speech in New York, were Dudley’s most detailed yet on the nuts and bolts of Fed operations once it begins to raise interest rates, probably some time next year.

Dudley also expressed his preference for continuing to keep the Fed’s $4 trillion-plus balance sheet stable until after the Fed begins to raise rates, a change to the Fed’s current blueprint for exiting its super-easy policies.

Until now the Fed has said it would first end its current policy of reinvesting the proceeds of maturing securities in its portfolio, and then start raising rates.

But that approach, Dudley warned on Tuesday, could cause financial markets to tighten too early, undercutting the Fed’s policies.

Dudley said that “early evidence” shows that the Fed’s new reverse repo facility would “would help strengthen our control over money market rates.”

That’s important, he said, because better control over short-term rates is likely to help the Fed keep a lid on inflation and inflation expectations. Under the facility, which the Fed has been testing for a year, banks, dealers, and money market funds effectively make overnight cash loans to the central bank, eliminating that liquidity from the system.

By contrast, Dudley suggested the Fed’s new term deposit program, designed to keep cash out of the banking system for longer than the traditional overnight timeframe, is “less attractive.” The Fed began testing a seven-day term deposit program this week.

Because the Fed would need to pay higher rates to compensate firms for locking up their money for longer, Dudley said, it would be a more expensive option than using the reverse repo tool. It could also mean the Fed would need to drain most of the $3 trillion of bank reserves before it could have the control it needs, he said.

“This could be done of course with effort, but is the effort worth it?” Dudley said.

Dudley raised a number of issues with the reverse repo facility, including the possibility of a run on the system in a crisis. But he suggested such problems could easily be addressed, for instance by capping overall usage.

The Fed will need to do more testing and analysis before making any decision, he said. For more on the Fed’s new alphabet soup of short-term rate tools.

“My goal would be to clarify our intentions later this year, long before we begin to contemplate raising short-term rates,” he said.

Reporting by Ann Saphir; Editing by Chizu Nomiyama

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