Factbox: Fed's exit strategy toolkit

NEW YORK (Reuters) - The U.S. Federal Reserve on Thursday raised the discount rate it charges on emergency loans it makes to banks.

The move represents a step in the Fed's plan to wean financial markets off the emergency measures it put in place to battle the financial crisis.

Fed Chairman Ben Bernanke last week said the discount rate could be raised soon and stressed the measure would not represent a tightening of monetary policy, a message reiterated by the Fed on Thursday.

Below are tools the Fed could use when it decides the time has come to tighten policy.

PAYING INTEREST ON EXCESS RESERVES

The interest rate the Fed pays on excess reserves will be the one to watch once the central bank begins to tighten policy.

By raising the rate it pays on bank reserves, the Fed creates a magnet for banks to keep those reserves with the Fed rather than lend them out into the financial system.

"By increasing the interest rate on reserves, the Federal Reserve will be able to put significant upward pressure on all short-term interest rates, as banks will not supply short-term funds to the money markets at rates significantly below what they can earn by holding reserves at the Federal Reserve Banks," Bernanke said in testimony to lawmakers on February 10.

A number of central banks around the world have effectively used similar tools.

LARGE-SCALE REVERSE REPURCHASE AGREEMENTS

The Fed could arrange large-scale reverse repurchase agreements (reverse repos), with financial market participants. They would temporarily drain reserves from the banking system and reduce excess liquidity at other institutions.

Reverse repos involve the sale by the Fed of securities from its portfolio with an agreement to buy them back at a slightly higher price at a later date.

The New York Fed's open market desk last year tested its ability to conduct term reverse repos with primary dealers -- its usual dealing partners -- using agency debt and Treasuries.

Minutes from the Fed's January policy meeting released on Wednesday showed Fed staff expect the central bank will be able to conduct reverse repos using mortgage-backed securities as collateral "early this spring" and would soon after be able to conduct them with an broader set of counterparties.

TERM DEPOSIT FACILITY

The Fed has proposed creating a new "term deposit facility" for banks, similar to certificates of deposit that banks offer retail customers. Like the reverse repos, this would reduce the supply of funds banks have available to lend to each other.

While the Fed already pays interest on reserves held overnight, a term deposit facility would lock up funds for longer. In its proposed rulemaking, the Fed said deposits would not exceed one year and would likely have maturities ranging between one and six months.

"The Federal Reserve would likely auction large blocks of such deposits, thus converting a portion of depository institutions' reserve balances into deposits that could not be used to meet their very short-term liquidity needs and could not be counted as reserves," Bernanke said on February 10.

He said the Fed expects to conduct tests on the term deposit facility in the spring.

The minutes of the January meeting showed that staff expect the facility to be operational as soon as May.

ASSET SALES

The Fed could sell a portion of its securities holdings into the open market.

"A reduction in securities holdings would have the effect of further reducing the quantity of reserves in the banking system as well as reducing the overall size of the Federal Reserve's balance sheet," Bernanke said on February 10.

"I currently do not anticipate that the Federal Reserve will sell any of its security holdings in the near term, at least until after policy tightening has gotten under way and the economy is clearly in a sustainable recovery," he said.

Bernanke added any sales would be at a gradual pace and would be clearly communicated to market participants.

The minutes showed other Fed policymakers hold a more favorable view of asset sales. Several thought it important to begin a program of asset sales in the near future to ensure that the Fed's balance sheet shrinks more quickly than if it relied on prepayments and redemptions of maturing securities.

(Compiled by Reuters' Fed reporting team; Editing by Dan Grebler)