By Richard Leong
NEW YORK (Reuters) - Interpreting Federal Reserve policy is hard enough, but the central bank may need to dust off its 'How to' guide to explain the nuts and bolts of new tools it will use when it finally starts to raise interest rates.
Traders and analysts in the past were accustomed to just glancing at the traditional federal funds rate. But managing that rate was easier when the banking system had about $800 billion in excess cash. With $2.5 trillion in reserves, the Fed's ability to control that rate is much harder.
The Fed has to look elsewhere to mop up reserves easily without causing dislocations. Now it has the TDF, RRP and IOER. Or rather, the term deposit facility, reverse repurchase agreements and interest on excess reserves - the three other programs that the Fed has signaled it will use when it attempts to normalize interest rates.
If successful, the combination of all three, along with how the Fed controls the fed funds rate, will usher in a new policy regime instead of the ultra-loose one it has clung to for the last five years.
But if this confuses investors, analysts fear the Fed could lose credibility and harm markets and the economy.
"The Fed is fumbling and working its way through it," said Eric Green, global head of rates and currency research at TD Securities in New York.
Most U.S. short-term market rates have been stuck in the single-digit to high-teen basis-point range since the Fed adopted its near-zero rate policy in December 2008.
The daily fed funds rate has averaged anywhere from 0.06 percent to 0.25 percent since January 2009, Fed data show. That hasn't mattered, because the Fed had no intention of moving rates during this extraordinary period of monetary policy.
"Right now, they don't have an issue. They are just setting a range for the fed funds rate and how it moves around doesn't matter to them. But as they exit, they might want to have more precise control of the market," said Ethan Harris, chief economist at Bank of America Merrill Lynch in New York.
The Fed in the past raised the overnight fed funds rate market by borrowing anywhere from $2 billion to $4 billion daily from top-tier Wall Street firms.
"They will pull multiple triggers to get what they want in terms of short-term interest rates," Harris said.
To make sure short-term rates hold up as it tightens, the Fed has ramped up testing of its "alphabet soup" programs.
Starting this week, it will offer banks seven-day term deposits, which bear interest rates higher than 0.25 percent, the top end of its policy rate range. These loans are a longer-term program to keep cash out of the banking system than the traditionally used overnight tools like the fed funds market.
This will help the Fed sop up excess bank reserves, which analysts say is necessary because of the sheer volume of reserves and because longer-term tools cause less short-term disruptions in rates markets.
"This is an additional tool, but this doesn't mean the Fed is out of the woods," said TD's Green.
The IOER, which is currently at 0.25 percent, offers banks income on excess reserves held at the Fed. The effectiveness of this program has been mitigated somewhat by the bank needing to hold capital against those reserves.
Arguably, the most critical tool are RRPs or reverse repos. These are geared to attract cash from money-market mutual funds and government mortgage finance agencies, which are not eligible for IOER and TDF and yet hold substantial cash.
The Fed has been paying 0.05 percent on its RRPs.
Money funds have $2.6 trillion in assets. Mortgage agency Fannie Mae had $14.1 billion in cash and $12.8 billion in fed funds and repos with banks at the end of March, while its sibling Freddie Mac held $10.6 billion in cash and $24.5 billion in repos.
Compared with the TDF, the reverse repo facility is a veteran of Fed operations. The Fed started talking about such a tool in July 2013, and is now using it regularly to drain excess cash from the banking system.
But with the mountainous task of "normalizing" policy, the Fed might need to rummage through its cabinets for even more tools.
(Reporting by Richard Leong; Editing by Dan Grebler)
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