Fed's latest invention holds promise for controlled rate rise

By Reuters

Nov 29, 2014 03:58 AM EST

The Federal Reserve's latest market proposal could help it smoothly raise interest rates and bring far more banks into direct contact with the U.S. central bank in a way that another tool, unveiled last year, could not.

Analysts have applauded a draft Fed idea to offer lenders segregated cash accounts to be used as collateral for transactions with private investors. Such accounts could be an "additional supplementary tool" as the central bank returns to a more normal policy stance, according to minutes of the Fed's Oct. 28-29 policy meeting, which were released last week.

The move would increase competition for funds in the short-term overnight market as smaller domestic banks would have far more access to the Fed's offered rate on excess reserves, analysts said. It could also help stabilize the financial system when demand surges for liquid funds.

"If left in place over the long term, segregated central bank cash accounts could radically remake the ways in which liquidity services are provided to the public," wrote Wrightson ICAP Chief Economist Lou Crandall.

While Crandall estimated the program could eventually expand to "several trillion dollars" in balances, UBS economists said it would be $400-$550 billion in earlier stages.

The brief, surprise mention of segregated accounts in the minutes suggests that the Fed's overnight reverse repurchase facility, a fixed-rate full-allotment tool known as "ON RRP" that has been tested since last year, could again be relegated in the Fed's toolbox.

Fed officials once telegraphed ON RRP, also meant to mop up excess reserves, as the primary tool for keeping a floor under rates when the time comes to tighten policy. But earlier this year the Fed said the rate it pays on excess reserves (IOER) would be the "primary" tool. It is unclear how important segregated accounts would be, if implemented.

Central bankers want as much control over market rates as possible when they raise the key federal funds rate from near zero, where it has been since late 2008. The worry is that the trillions of dollars in newly created bank reserves could complicate that tightening. But adding segregated accounts could boost the supply of quality money-market instruments, lifting borrowing costs.

Simon Potter, head of the New York Fed's market operations, mentioned at the meeting possible next steps to investigate any issues with carrying out the program, the minutes said.

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