Fed Bolsters Tool Kit for Lifting Interest Rates



Fed Bolsters Tool Kit for Lifting Interest Rates

Central bank boosts potential size of reverse repo program designed to put a floor underneath short-term rates

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A silhouette of a Federal Reserve police officer outside the Fed building in Washington. The central bank on Wednesday said it was lifting the daily cap on its reverse repurchase program to around $2 trillion, from its current $300 billion. Photo: Andrew HarrerBloomberg News

By

Michael S. Derby and

Katy Burne

Updated Dec. 16, 2015 6:13 p.m. ET

3 COMMENTS

WASHINGTON—The Federal Reserve said on Wednesday it is boosting the size of a program it will use to set a floor under short-term interest rates as part of its effort to increase the cost of borrowing in the U.S. economy.

The Fed announced the move after a meeting where it decided to lift short-term interest rates off the near-zero levels they have rested since the end of 2008. The Fed also updated other details of the mechanics it will use to boost borrowing costs.

Most notably, the Fed said it was lifting the daily cap on its reverse repurchase program to around $2 trillion, from its current $300 billion. The change represents the most the central bank can do on that front, given that the cap is tied to the amount of Treasurys the Fed currently has available for the program.

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“They don’t want to be at day one of liftoff where things don’t trade in the range,” said Zoltan Pozsar, a strategist at Credit Suisse Group.

The decision on the terms of the reverse repo program comes as part of a central-bank effort to put into play a new and largely untested set of tools for influencing borrowing costs throughout the U.S. economy.

The Fed said Wednesday it would raise the target range for its benchmark federal-funds rate by a quarter percentage point, to 0.25% to 0.50%. It plans to use two interest rates to set the upper and lower bounds of the range.

The Fed will seek to set the upper level of the range by raising the interest rate it pays deposit-taking banks on the money, called reserves, they park overnight at the central bank. The so-called IOER rate will be lifted to 0.50% from 0.25%.

It will try to set the lower bound, or a floor under short-term rates, with the interest rate it pays institutions like money-market funds on the reverse repurchase agreements. Through the program, the Fed borrows money overnight in exchange for Treasurys owned by the central bank. It will raise the repo rate to 0.25% from 0.05%.

Using these tools, the Fed will seek to drain money from the financial system, moving rates higher to prevent the economy from overheating. Fed officials are raising rates not to slow growth, but to reduce the amount of stimulus they are providing.

The Fed said the total size of the reverse repo program was determined by the amount of Treasury securities now owned by the central bank that would be available for reverse repos.

Ahead of the Fed’s decision, many traders had expected the Fed to raise the cap on the reverse repos to between $500 billion and $1 trillion, in part because the central bank had been ambiguous about how aggressively it wanted to use the tool. Some also have been concerned that an overly large program could distort the functioning of markets.

“The Fed is making it very clear they want to get interest rates up, so having this big reverse repo tool is the key to that,” said Ethan Harris, co-head of global economics at Bank of America Merrill Lynch.

David Kotok, chairman and chief investment officer at Cumberland Advisors, an asset manager overseeing $2.4 billion, said “markets liked it.” He said he was expecting the Fed to suspend the cap on the reverse repos.

The Fed didn’t say how long it will maintain the reverse repo’s new size, but officials in the past have suggested the reverse repo effort would be phased out over time.

The details laid out by the central bank represent a significant shift in how the central bank seeks to influence borrowing costs. In recent decades, the Fed adjusted the fed-funds rate—the rate on overnight loans between banks—by buying or selling Treasurys, which added or decreased the total amount of banks’ reserves. But the large amount of reserves added to the system since the crisis has made this approach less effective.

Fed officials believe their new tools will allow the central bank to control short-term rates.

The Fed didn’t comment on its long-run plans for its $4.5 trillion balance sheet. It said it would continue to use the proceeds of maturing securities to buy new bonds to keep the size of Fed holdings steady.

Write to Michael S. Derby at michael.derby@ and Katy Burne at katy.burne@

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