The New York Federal Reserve officials tasked with prying interest rates off the floor have been meeting with bankers and traders to plot how best to do it, amid deep uncertainty over how much control they will really have over short-term lending markets.
With the U.S. central bank expected to raise rates later this year, Simon Potter and his team of market technicians have the tricky job of implementing higher rates using some new and lightly tested tools as well as some that may not work as well as in the past. They’ll be operating under intense global scrutiny that’s centered on the prospects for the world’s biggest economy.
Even while testing new methods meant to sweep up trillions of dollars of reserves from financial markets, Potter’s team is preparing for volatility and to make on-the-fly adjustments when the time comes, according to interviews with Fed officials and market participants.
The trouble is that the federal funds market, the intra-bank trading pool traditionally used by the Fed to meet its policy goals, has shrunk to about a quarter of its pre-crisis size after more than six years of unprecedented monetary stimulus.
“There is a lot more uncertainty in the mechanical features of the outlook than people admit to,” said Joseph Abate, a money-market strategist at Barclays Capital.
The Fed wants to avoid a scenario in which yields don’t rise enough after it lifts the fed funds rate because banks, flush with $2.5 trillion of reserves parked at the central bank, don’t need short-term funding.
The central bank also risks being drawn so deeply into money markets that it destabilizes things.
That’s why the New York Fed, already under political pressure due to regulatory missteps, is taking every precaution it can to protect its credibility and that of the central bank. It wants to make sure that when the central bank decrees higher rates, yields will actually rise.
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