The Federal Reserve had to step into financial markets on Tuesday to keep interest rates from rising above its target, the first time the central bank has had to carry out this type of “market operation” since the global financial crisis.
The Federal Reserve Bank of New York had to spring into action to keep the effective fed funds rate in line after it rose to the very top of the Fed’s 2 to 2.25 percent range. The central bank branch announced on Tuesday that it would conduct its first major repurchase market operation since the Fed changed its policy-setting approach during the Great Recession.
But the operation was bedeviled by technical difficulties, forcing the Fed to delay the intervention. It was carried out 20 minutes later than initially planned.
The move came after the overnight rate on Treasury repurchase agreements, which are short-term loans used by financial institutions like hedge funds and banks, surged at the start of the week amid a shortage of dollars. A few factors seemed to give rise to that shortfall: companies withdrew cash from money markets to pay their taxes shortly after the United States Treasury issued a raft of new bonds. That glut of new debt sapped up cash.
The surge in repurchase rates — commonly called repo’s — spilled over to the Fed’s main policy tool, the federal funds rate, driving it to 2.25 percent as of Monday.
Tuesday’s intervention is symbolically important. The central bank decided just this year to keep its balance sheet large enough that it can set its policy rate without active market operations. But this episode suggests that it may not have kept its holdings big enough for that approach to work amid more extreme market conditions.
Banks increasingly hang onto reserves — currency deposits — in part because of post-crisis regulation. Even though the overall amount of reserves in the banking system remains high, with excess reserves at about $1.4 trillion, the cash no longer flows readily to patch up short-term shortages.
That makes market stress like this week’s possible, and means that the Fed can set things right with a relatively small intervention.
“For some time now, we’ve had September 16 circled as the first day of the rest of the repo market’s life,” said Lou Crandall, chief economist of Wrightson ICAP. He said that the recent dislocations suggest that the Fed’s goal of setting rates without fairly regular market operations “may not be realistic.”