NEW YORK (Reuters) - The Federal Reserve aggressively expanded a new policy tool to help it raise U.S. interest rates from near zero, saying on Wednesday it anticipated about $2 trillion in bids for a facility to help mop up excess cash in financial markets after years of stimulus.
The U.S. central bank, which raised rates modestly on Wednesday as expected, said there would effectively be no limit on a so-called overnight reverse repurchase programme (ON RRP) that is now capped at $300 billion.
The tool would be “limited only by the value of Treasury securities held outright,” the New York Fed said in a statement. The Fed held some $2.5 trillion in Treasury bonds last week in its portfolio of nearly $4.5 trillion total.
Analysts had expected the Fed to only double the size of the repo programme to around $600 billion. But policymakers have repeated they wanted to prove they could still control short-term markets.
“It’s effectively un-capped because they are willing to reverse repo out all the securities they have available,” said Louis Crandall, chief economist at Wrightson ICAP in Jersey City, New Jersey.
The decision suggests Fed policymakers are doing all they can to ensure that rates, which have been at rock bottom for seven years, will actually rise on Thursday despite some $2.6 trillion in excess bank reserves flooding financial markets and making the job far more difficult than in the past.
The nightmare scenario would be that short-term borrowing costs do not rise enough due to years of Fed bond-buying meant to stimulate the choppy U.S. economic recovery.
Beginning Thursday, the reverse repo rate will be set at 0.25 percent, from 0.05 percent now, and serve as the “floor” to the new target policy range of 0.25-0.50 percent. A rate the Fed pays primary dealers on excess reserves will serve as the “ceiling” at 0.5 percent.
The reverse repo programme has been tested for more than two years but has not yet been relied upon for a policy change. It will be available to some 160 money market funds, banks, and government-sponsored entities that can earn 0.25-percent interest from the Fed for parking cash there overnight.
The cap on individual bidders remained at $30 billion.
The New York Fed, which conducts U.S. monetary policy three blocks off Wall Street, said it “anticipates that around $2 trillion of Treasury securities will be available for ON RRP operations.”
“In the highly unlikely event” that bids surpass that level, it will run auctions to fill demand until all Treasuries are expired. Bids at the limit “stop-out rate” would be filled on a pro rata basis, the New York Fed said.
The Fed’s first tightening in more than nine years represents a big step on the tricky path of returning monetary policy to a more normal footing after the deep 2007-2009 recession and financial crisis.
The unprecedented easing has eclipsed the effectiveness of the federal funds market as the central bank’s primary policy lever.
A smooth liftoff will be up to a team of traders in the New York Fed’s “operations room,” who on Thursday morning will closely monitor key short-term rates to determine whether markets are cooperating. They will run the repo auction between 12:45 and 13:15 Eastern (1745-1815 GMT) with the dozens of firms that do not usually do direct business with the Fed.
The Fed can also turn to term repo and deposit facilities as needed to lift market rates.
The next big decision for the Fed, likely after a few more rate hikes, will be when and how far to go in shrinking its portfolio of Treasury and mortgage assets, either by allowing them to run off naturally or by selling outright, a less likely option. For now it is topping up the balance sheet as assets mature.
“That (decision) is going to preoccupy the Fed for the next six to twelve months,” said Scott Minerd, chief investment officer at Guggenheim Partners, in Los Angeles. “They admitted themselves they are in uncharted territory.”
Some policymakers and outside experts are also saying the Fed could choose to keep the portfolio big to stabilise financial markets and to provide an additional policy tool to target sectors of the economy or bond market.
Former Fed Chairman Ben Bernanke said last month that leaving the balance sheet as is “wouldn’t be a problem.”
Fed Chair Janet Yellen, speaking on Wednesday, said: ”I can’t tell you exactly what size of balance sheet we will determine is the best to operate in an efficient and effective manner.
“It might be somewhat larger than the very tiny quantity of reserves that we had in pre-crisis,” she added. “We have not determined that.”
The central bank had about $900 billion in assets before the crisis.
Reporting by Jonathan Spicer; Editing by Chizu Nomiyama