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Fed Risks New Distortions When It Raises Interest Rates

New tools to mop up liquidity could put the central bank at the center of money markets that are already under pressure from new regulations

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The Federal Reserve Bank of New York will be play a key role in executing the mechanics of the central bank’s expected interest-rate increase. Photo: Peter Foley for The Wall Street Journal

By

Katy Burne

Dec. 15, 2015 1:22 p.m. ET

33 COMMENTS

When traders at the Federal Reserve Bank of New York’s Manhattan headquarters get the order to raise interest rates for the first time in nearly a decade, they will be urged on by a plaque down the hall that reads: “Execute policy like a champion today.”

Easier said than done. The central bank spent years pumping more than $2.5 trillion into the financial system in hopes of stimulating the economy. Now it risks creating a whole new set of distortions as it tries to pull the cash back out.

Fed officials are expected to vote to raise benchmark short-term interest rates from near zero at the conclusion of their two-day policy meeting Wednesday.

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It won’t be like throwing a switch. Instead, the New York Fed’s traders will be swapping securities and cash with big financial institutions, trying to control supply and demand for money in markets already under pressure from new regulations on banks and money-market funds.

A great deal is at stake. Fed tightening traditionally sends up rates on everything from mortgages and car loans to the cost of financing the U.S. deficit. Flubbing the maneuvers could raise questions about the Fed’s credibility.

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“There is discussion about how, with the Fed putting all the liquidity in, there are tools large enough to get the fed funds rate up,” said Scott Skyrm, head of fixed-income financing, futures and rates at Wedbush Securities Inc., a broker-dealer.

The Fed used to set its benchmark rate—the federal funds rate, charged on overnight loans between banks—by buying or selling U.S. Treasurys, which added or drained the funds banks had on reserve at the Fed, and small changes were enough to move rates.

The scale of the current effort has forced it to devise new tools.

New York Fed President William Dudley told The Wall Street Journal in late September he is “highly confident” the tools can work.

Of particular concern to some people inside and outside the Fed is something called the reverse repo facility. With reverse repos—shorthand for reverse repurchase agreements—the Fed will borrow money overnight from institutions like money-market funds while letting them hold Treasurys as collateral until it pays them back and starts another round of trades the next day.

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The Fed has trillions of dollars of Treasurys on its balance sheet that it can offer as collateral, making the reverse repos a potentially useful tool for draining the excess cash still swirling around the financial system, left over from the bond-buying programs the Fed used to fight the 2008 crisis.

The concern is that the program risks making the central bank too big an influence in the money markets, where companies and individuals park cash that they need to be able to access quickly. One risk is that money-market funds could create liquidity problems by choosing to invest their cash with the Fed rather than lend it to banks in times of stress.

“It could change the structure of the short-term money markets in ways that most people find hard to predict,” former Philadelphia Fed President Charles Plosser said in an interview.

The $2.7 trillion U.S. money-market fund industry is already in the process of adjusting to new rules that won’t apply to funds that invest solely in debt issued by the federal government and its agencies. Analysts said funds holding as much as $1 trillion in assets could convert to investing only in government securities. That is giving them an added incentive to invest in the Fed’s reverse repo program and pick up the Treasurys as collateral.

Separately, large banks including J.P. Morgan Chase & Co. and State Street Corp. have grown reluctant to hold excess cash deposits, sending billions of dollars in search of a safe new home, including Treasurys available through the reverse repos. Meanwhile, constraints on government borrowing have limited the supply of Treasury bills available to meet all the demand.

Is the Fed finally ready to start raising interest rates? Greg Ip and John Hilsenrath discuss the risks facing the Fed and whether global developments and weak economic data could hold the Fed back.

The Federal Reserve has kept interest rates at near zero since the 2008 financial crisis. To raise them, it has come up with a new set of tools. Produced by Katy Burne, Christopher Kaeser, Arielle Ray and Mark Scheffler. (Sept. 17)

“The Fed is squeamish about the reverse repo program partly because it involves increasing its presence in money markets, and partly because it’s effectively providing a safe asset in size in a market starved of one,” said Joseph Abate, money-markets analyst at Barclays PLC.

Because of such concerns, Fed officials want to phase out the repo facility soon after interest-rate liftoff, according to minutes of their recent policy meetings.

Publicly, Fed officials have been ambiguous about how aggressively they will use the reverse repos. In March, Fed officials said they could raise or remove the repo program’s daily limit, currently set at $300 billion.

The initial rate hike is only expected to be quarter percentage point, and the central bank has other tools to influence rates.

Chief among them is a plan to pay a higher interest on the reserves that banks park in their accounts at the Fed. Some financial institutions like mortgage giant Fannie Mae and the federal home-loan banks are excluded from earning interest on their deposits at the Fed, so the reverse repos will be used to soak up their excess funds.

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Brian Sack, chief global economist at hedge fund firm D.E. Shaw Group and a former markets chief at the New York Fed, said he suspects the Fed will have to keep its reverse repo facility in place for years to have adequate control over rates.

The actual mechanics of the reverse repos are somewhat clunky. Traders at the New York Fed will press a series of buttons in a system called FedTrade that links it with Wall Street banks. Banks and others logging into FedTrade will hear a sequence of three musical notes—F-E-D—and see a pop-up window that signals the Fed is about to enter the market.

The bidding is open to more than 150 banks, money-market funds and government-sponsored enterprises including Fannie Mae and Freddie Mac, but they can gain access only by using a special USB stick or token. Some traders bidding on behalf of more than one fund have complained about having to remove the token and insert a new one for each fund.

It used to be worse. In the 1970s, when Paul Volcker was president of the New York Fed, officials shut the doors to the trading room when they were entering the market and made visitors freeze on the spot until the results were announced, said Bruce English, a retired senior vice president at Aubrey G. Lanston & Co., a former primary dealer.

To this day, phones at the Fed provide direct lines to primary-dealer desks. “When that line blinked, all action stopped,” Mr. English said.

Write to Katy Burne at katy.burne@

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