Treasury advisory group sees issues with Fed exit

NEW YORK Nov 4 (Reuters) - The U.S. Federal Reserve's tools for removing an unprecedented array of emergency lending facilities are fraught with risks of their own, according to a high-level advisory group to the Treasury Department.

The U.S. central bank is currently meeting to discuss the course of monetary policy, and an eventual exit strategy is expected to feature prominently in the debate.

But minutes from the Treasury Borrowing Advisory Committee released on Wednesday suggest market participants are not yet convinced that the move away from massive liquidity provisions will be a simple affair.

One possible way to remove stimulus is to raise the interest paid on reserves. Congress gave the Fed this authority last year, as the global financial crisis reached its apex following the bankruptcy of investment firm Lehman Brothers.

Yet timing will be key if Fed officials wish to avoid derailing any recovery.

This approach "carries the attendant problems of increasing interest rates too soon in the economic recovery," said one member of the Treasury advisory group, according to the minutes, which did not name specific individuals.

The committee is made up of top executives at large banks known as primary dealers, who do business directly with the Fed. Matthew Zames, a managing director at JP Morgan, is its chairman.

Another key mechanism for removing reserves would be the introduction of a "term deposit facility" that would offer financial institutions the incentive not to lend over a given period.

However, this option "lacks a clear mechanism for rate setting and bank use," the same Treasury advisor said.

Another, more blunt way to drain credit from the banking system would be the outright sale of Treasury and mortgage-backed debt, which the Fed has accumulated in earnest in an effort to keep long-term interest rates low and stimulate mortgage activity.

Yet this method might prove particularly risky, since it could put upward pressure on interest rates, thwarting economic recovery.

"Selling assets may run into difficulties if the public appetite for debt at that time is sated, especially considering the impact on the housing market and the major role the Federal Reserve currently plays in the market," the minutes said.

The central bank recently stopped purchasing Treasuries, drawing its $300 billion buying program to a close. It has also committed to buying up to $1.45 billion in mortgage-backed securities and agency bonds.

Even reverse repurchase agreements, seen as the most conventional tool in the Fed's kit, could have some issues.

"The program will compete with other short-term investments and put upward pressure on Treasury bill rates," the minutes said. "Moreover, draining excess reserves may dampen the demand for Treasury securities by banks." (Reporting by Pedro Nicolaci da Costa; Editing by Theodore d'Afflisio)