The Federal Reserve stepped into financial markets on Tuesday to keep short-term interest rates from rising — 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 range of 2 to 2.25 percent. The central bank branch, which acts as an intermediary between the Fed and financial markets, 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 25 minutes later than initially planned. The New York Fed announced Tuesday that it would conduct a second, similar operation on Wednesday to help keep the fed funds rate in its target range.
The moves 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 funds from money markets to pay their taxes shortly after the United States Treasury issued a raft of new bonds, which also sopped up cash.
“The size of what left the market was larger than, I think, what people who were financing positions were expecting,” said Alex Roever, head of United States interest rates strategy at J.P. Morgan. “That mismatch sort of caught the market off guard. And I think it’s that simple.”
The surge in repurchase rates — commonly called repos — 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, because it suggests the Fed’s approach to setting interest rates may require fine-tuning.
Before the financial crisis, the New York Fed used regular market operations to coax the fed funds rate into place, routinely buying and selling securities to achieve the desired rate. But since October 2008, the central bank has nudged its policy rate into position by paying interest on excess reserves — deposits that commercial banks park at the Fed.
Fed officials decided just this year to stick with that new operating approach, which had proven reliable while allowing the central bank to be less active in markets.
To stick with the new approach, the Fed had to commit to keeping its balance sheet bigger than it was before the last recession — back then, reserves were scarce, and they now need to be ample. To that end, the Fed stopped its effort to shrink its balance sheet as of last month.
But the fact that intervention was needed suggests that it may have allowed its balance sheet to get too small for the new approach to work without active help from the Fed when market conditions are irregular.
Even though the overall amount of reserves in the banking system remain high, with excess reserves at about $1.4 trillion, cash no longer flows out readily to smooth over temporary shortages. The hoarding happens partly because banks now hang onto their reserves to satisfy post-crisis rules.
That enables market stress like this week’s gyrations, and means that the Fed can set things right with a relatively small intervention. The Fed’s operation to inject funds ultimately amounted to just over $53 billion.
“Without flexibility in balance sheets, these types of spikes in repo rates may be unavoidable,” said Seth Carpenter, United States chief economist at UBS and a former Fed official. “The Fed may need to be ready.”
The central bank could lower the rate of interest it pays on excess reserves at its meeting Wednesday, a technical tweak that it has made several times to help to keep rates within its desired range. The Fed is expected to lower its benchmark interest rate at that meeting by a quarter-point.
The Fed may now need to revisit its operating plan rather than relying on such minor adjustments.
It could be that the supply of excess reserves is now small enough that short-term stresses — like the coming due of corporate taxes this week — will feed through into repurchase rates and the fed funds rate more regularly.
“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 this week’s dislocations suggested that the Fed’s goal of setting rates without fairly regular market operations “may not be realistic.”
And if outright intervention is needed again, the Fed should be better-prepared, economists said. While Tuesday’s 25-minute delay seems short, it is a big deal to markets, where moves are often measured in milliseconds.
“It’s a bit of a black eye,” said Gennadiy Goldberg, a rates strategist at TD Securities. “I think of a firefighter coming up with a hose, turning it on, and there’s nothing there. And then he says: ‘I’ll come back later.’”
The glitch could hurt confidence, Mr. Carpenter said, “and in some sense confidence is a big part of market functioning.”
The New York Fed declined to comment on the operation.
The market for repurchase agreements is an important, but often-overlooked part of the large markets for short-term debt, referred to as money markets.
Repo rates are often quite low and hover close to the short-term interest rates the Federal Reserve sets.
But the spike in repo rates this week — the rate surged to more than 4 percent at times on Monday before falling back to more normal levels — showed that is not always the case. And it seemed to influence other important short-term money market rates, including the fed funds rate. When the repo rate again began to spike on Tuesday, it prompted the Fed’s intervention.
Fed officials, who are meeting this week in Washington, could also discuss, and maybe even announce, when they will begin to allow their balance sheet to increase in size again. Officials are currently holding it steady, but it typically would expand alongside the economy.
“It really seems that we’ve just hit a trip point where the Fed needs to start debating growing assets again,” said Jonathan Hill, United States rates strategist at BMO Capital Markets in New York.
