The Federal Reserve is considering a new tool to help drain cash from the banking system and keep short-term interest rates on target when it shifts from its current cheap-money policy, minutes of the Fed's July policy meeting showed on Wednesday.
Fed policymakers were briefed during the July 30-31 meeting on the potential for creating a fixed-rate facility for overnight reverse repurchase agreements, or reverse repos.
"They are setting the stage for an eventual policy tightening by sometime in 2015," said Mary Beth Fisher, head of U.S. interest rates strategy at SG Corporate & Investment Banking in New York.
Reverse repos go together with the interest the Fed pays on excess reserves and the term deposit facility as tools to control short-term interest rates when the central bank is ready to normalize rates from their rock-bottom levels.
They also broaden the number of participants the Fed can tap to help reduce the amount of cash in the financial system in addition to the 21 primary dealers, which are Wall Street firms that do business directly with the Fed.
The counterparties for reverse repos include U.S. subsidiaries of foreign banks, money market funds and mortgage finance agencies Fannie Mae and Freddie Mac.
"In general, meeting participants indicated that they thought such a facility could prove helpful," the Fed's minutes said.
The Fed adopted a near-zero interest rate policy in December 2008. It has kept its target on the federal rate or the overnight borrowing cost on excess reserves between banks in a range from zero to 0.25 percent.
In an overnight reverse repo transaction, the Fed would sell a Treasury bond to a U.S. primary dealer or a large money market fund and buy it back the next day for a slightly higher price. The transaction temporarily takes cash out of the banking system, while the dealer or fund earns interest on the deal.
Reverse repos could gain importance as a money market investment as the amount of ultra-short debt issued by the U.S. government and mortgage finance agencies is expected to shrink in the coming years, analysts said.
This reverse repo facility, if adopted, would make it easier for the Fed to engage in large-scale reverse repos with all the counterparties, analysts said.
"It's another monetary policy tool that could affect money market rates. The Fed wants the counterparties to pre-commit to a certain amount of exposure. They want to simplify the mechanics of the transactions," said Boris Rjavinski, rates and rate derivatives strategist at UBS in Stamford, Connecticut.
While they expressed interest, there was no indication as to when the policymakers might decide to go ahead with a reverse repo facility.
The Fed has plenty of assets to reduce money supply after three rounds of massive bond purchases, or quantitative easing. These moves have more than tripled the size of the Fed's balance sheet to $3.6 trillion, with $2 trillion in Treasuries securities.
The central bank has been holding small-scale tests with primary dealers and money market funds since 2009 to determine its readiness to conduct reverse repos.
While the concept of a reverse repo facility supports the notion that the Fed is preparing for an eventual rise in interest rates, SG's Fisher said it is not a signal from the Fed about tightening policy while it considers reducing its $85 billion monthly bond purchases later this year.
"It is not a message" about pending changes in Fed policy, she said of the reverse repo facility mentioned in the minutes.
(Reporting by Richard Leong.; Editing by Dan Burns, Chizu Nomiyama, Andre Grenon and Kenneth Barry)