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
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.