The U.S. Federal Reserve took steps on Friday toward creating tools that could help it eventually withdraw the billions of dollars it pumped into the economy to support economic recovery.
The Fed's Board of Governors said it authorized a term deposit facility, similar to certificates of deposits banks offer their customers, that could be used by the Fed to lock up excess cash. The New York Federal Reserve moved closer to testing reverse repurchase agreements with money market funds by posting a master agreement on its website.
Both the term deposit facility and large-scale reverse repos are ways the Fed could reduce the supply of funds banks can lend to each other, steps aimed at ensuring inflation does not take hold once the economic recovery gathers steam.
The U.S. central bank stressed in a statement that the development of the Term Deposit Facility is a matter of prudent planning and has no implication for the near-term conduct of monetary policy. The Fed this week renewed its pledge to keep benchmark interest rates extraordinarily low for an extended period.
In its effort to battle the worst financial crisis since the Great Depression, the Fed has deployed an extraordinary array of emergency measures, leading to a surge in its balance sheet to more than $2 trillion.
Analysts are closely watching the developments of these tools, with some warning the exit from the Fed's extraordinary support for the financial system is wrought with possible missteps.
It's unclear how much capacity the Fed is going to have to drain reserves through either of these tools, said Lou Crandall, chief economist at Wrightson ICAP in New York.
Fed officials have said these tools can be used in addition to the interest the Fed can pay on overnight reserves that banks park with the central bank.
William Dudley, the president of the New York Fed, has likened interest on reserves to the Fed's belt and the term deposit facility and reverse repurchase agreements to its suspenders.
Through the term deposit facility, regional Fed banks will be able to pay interest on longer-term deposits to firms already eligible to receive interest on overnight reserves. The Fed said it expects to conduct small-value offerings of term deposits in coming months to test the mechanism.
The New York Fed on Friday posted on its website a master agreement it will use with money market funds to engage in reverse repos. The contract details the steps the New York Fed and money market fund counterparties will have to take to enter a reverse repo agreement.
In a repurchase agreement, the Fed makes collateralized loans to borrowers, temporarily adding reserve balances to the banking system, while a reverse repo drains reserves. The Fed has said it is expanding the counterparties it uses for reverse repos in order to be able to conduct them on a larger scale.
The contract for money market funds posted on the New York Fed's website clears the way for testing, but does not signal that a major reserve drain is imminent, said Alex Roever, a fixed-income strategist at JPMorgan Securities in New York.
Other tools the Fed could use for tightening include outright sales of assets.