The New York Federal Reserve next week will begin tests of a new tool being developed to help it better control the level of short-term interest rates once the Federal Reserve finally starts to raise its official interest rate.
The New York Fed will start testing an overnight, fixed-rate full-allotment, reverse repurchase agreement facility in a series of daily operations, the bank said in a statement released Friday.
The statement sparked some selling of short-dated Treasuries, though some traders said that fears over the application of the facility were probably overstated as it is unlikely to be implemented for some time.
Six-month Treasury bill yields rose to 5 basis points on Friday, from 3.5 basis points on Thursday.
In reverse repurchase agreements, or reverse repos, the Fed temporarily drains cash from the financial system by borrowing funds overnight from banks, large money market mutual funds and others, and offering them Treasury securities as collateral. Banks and the funds receive a modest overnight interest rate, initially set at 0.01 percentage point, or 1 basis point.
The development of the facility was first revealed last month when the minutes of the Federal Open Market Committee's July meeting were released.
The tool is designed to mop up excess cash in the financial system, which if left unchecked could keep rates lower than perhaps desired by the Fed at a later date. If successful, it could smooth what may be a rocky transition to tighter monetary policy when the U.S. central bank finally decides the economy is strong enough to withstand higher interest rates.
Years of pumping so much money into the market has left it awash in bank reserves, an unprecedented situation that has sowed concern that a policy turn will not be so easy and could distort key money markets.
The Fed is not expected to start raising its official policy rate, the Federal Funds Target Rate, until 2015, according to interest rate futures markets. On Wednesday the bank defied market expectations and decided to keep pumping cash into the banking system through its quantitative easing program.
(Reporting by Dan Burns and Karen Brettell; Editing by James Dalgleish and Leslie Adler)