NEW YORK Aug 22 The U.S. Federal Reserve may need to drain up to $2 trillion from the financial system when it decides to normalize short-term interest rates, according to Joseph Abate, Barclays' money market strategist.
This huge sum of liquidity reduction would be needed for the central bank to achieve its rate target due to the high level of reserves banks have now, which has curbed their demand to borrow from the federal funds market, Abate said in a research note released on Thursday.
"Since banks are all long cash in their reserve accounts at the Federal Reserve, they do not need to borrow reserves in the funds market and consequently trading activity has dried to a trickle," Abate wrote in the research note.
Banks typically borrow from one another's excess reserves in the fed funds market to help meet their reserve requirement.
The U.S. central bank influences the level of excess reserves through its open market operations, namely repurchase agreements and reverse repurchase agreements - also known as repos and reverse repos.
Repos add cash to the banking system as the Fed would buy a Treasury bond from a U.S. primary dealer and sell it back at a later date. Reverse repos reduce cash from the banking system as the Fed would sell a Treasury bond to a primary dealer and buy it back at a later date.
By adjusting the levels of excess reserves through these operations, the Fed can achieve its interest rate objectives.
The issue of how the Fed will achieve its rate target when it moves away from its near-zero rate policy resurfaced in the Fed's minutes from its July 30-31 policy meeting, which were released on Wednesday. The records showed policy-makers were briefed on the potential of a reverse repo facility, which analysts say would enable the Fed to conduct large-scale reverse repos.
Moreover, the process for the Fed to normalize monetary policy could last into the end of this decade, Abate said.
"Depending on the growth pace of currency in circulation, the adjustment process - assuming it begins in late 2014 - could last until 2019 or later," he said.
The Fed's policy normalization will likely cause distortion in money markets, which already face challenges from tougher domestic and international bank regulations, he said.
"Thus, efforts to restore the fed funds rate as a policy target in the face of these potential market distortions might be less than fruitful," Abate wrote.