Fed to test tool to drain excess reserves

10/20/2009

WASHINGTON - The Federal Reserve is testing one tool for draining some of the unprecedented amount of money plowed into the economy to ease financial woes and revive business activity.

The Federal Reserve Bank of New York, in a statement yesterday, said investors and others shouldn't read into the tests anything about the timing of when the central bank will need to reverse course and start boosting interest rates and removing other supports to fend off inflation.

"This work is a matter of prudent advance planning by the Federal Reserve, and no inference should be drawn about the timing of monetary policy tightening," the New York Fed said.

The tool being tested: so-called reverse repurchase agreements. That's when the Fed sells securities from its portfolio with an agreement to buy them back later.

"We have recently begun testing this capability with all involved parties and systems, and it is likely that the Federal Reserve will engage in additional tests in the future," the New York Fed said. "No actual operations have been conducted as part of these tests."

Reverse repos have been in the Fed's tool kit for years as a way to mop up money in the economy. They most recently were used in December, 2008, the Fed said.

This time around, the Fed is considering selling its securities to a broader set of investors - beyond the traditional big "primary" securities dealers such as Banc of America Securities, Citigroup Global Markets, and JPMorgan Securities.

Fed Chairman Ben Bernanke has said such large-scale reverse repurchase agreements can be done with banks, Fannie Mae and Freddie Mac, and other institutions. Some analysts have said that might involve transactions with money-market mutual funds.

The goal of the tests is to make sure all systems are in place to carry out the operations smoothly - if approved by the Fed - when the time comes. During the last year, the New York Fed has been working internally and with "market participants" (which weren't identified) on operational aspects of the reverse repos.

Knocked down by the worst recession since the 1930s, the economy is struggling to mount a lasting recovery.

To foster the recovery, the Fed recently decided to leave a key bank lending rate at a record low near zero, and pledged to hold it there for an "extended period." Many economists predict rates will stay at super-low levels through the rest of this year and into part of next year.