UPDATE 2-U.S. Treasury to let supplementary Fed balance fall

(Recasts, adds quotes, background)

By David Lawder

WASHINGTON, Nov 17 (Reuters) - The U.S. Treasury on Monday said it will allow the balance to dwindle in a program aimed at helping the Federal Reserve manage its balance sheet as the U.S. central bank has pumped liquidity into malfunctioning financial markets.

The move gives the Treasury, which faces enormous government funding needs, some breathing room under its statutory debt ceiling and diminishes a tool the Fed had at its disposal to provide funds to markets without driving down interest rates.

The Treasury Department said in a statement it is allowing its Federal Reserve Supplementary Financing Account balance to decline in the coming weeks as cash management bills sold to fund the program mature.

The Treasury said it has opted not to refund these bills in order to preserve flexibility in its debt management policies to meet large government financing needs.

"By lowering the amount of the (Supplementary Financing Program), which was financed by issuance of bills, the Treasury gives itself further room under the debt ceiling" of $11.315 billion, said Michael Feroli, an economist with JPMorgan Economics in New York, in a note. Total public debt subject to the limit stood at $10.548 trillion on Nov. 14, according to Treasury data.

The Fed supplementary financing account, created to help the Fed meet its liquidity facilities, stood at $508.956 billion, Treasury data showed.

The Treasury is ramping up its debt issuance plans to cope with what some of its bond dealers estimate as a $2.1 trillion borrowing need in the 2009 fiscal year that started Oct. 1.

"The Treasury is facing a huge cash needs," said Lou Crandall, chief economist for Wrightson ICAP in Jersey City, New Jersey.

The cost of government financial bailout programs and falling revenues as the U.S. economy slows to recessionary levels have prompted the Treasury to resurrect the 3-year note and plan more frequent auctions of 10-year notes and 30-year bonds in coming months.

The Fed has initiated a series of facilities aimed at providing access to hundreds of billions of dollars of funds for financial firms as part of efforts to prop up the financial system, which has been thrown into disarray.

Congress in early October gave the Fed immediate authority to pay interest on bank reserves. That gave the U.S. central bank more power to flood markets with cash without driving its benchmark federal funds rate below target.

The Treasury created the SFP to sterilize the excess reserves that were being created by the expansion of the various Fed liquidity programs, Feroli said. Reserves used by the public to purchase bills would be placed on deposit by the Treasury at the Fed and would therefore no longer be in the hands of the public, he added.

The Fed's most recent auctions for short term funds have shown a cooling in bank demand for the Fed funds. Last week's forward auction of $150 billion in 17-day funds attracted only $12.6 billion in bids, for a bid-to-cover ratio of just 0.08 -- an indication that a loosening of credit markets may mean fewer banks need to turn to the Fed for liquidity. (Additional reporting by Mark Felsenthal; Editing by Leslie Adler)