The Federal Reserve Bank of New York's research chief detailed the case for an additional policy tool to raise interest rates that would reduce dealings with the shadow-banking system when the time comes to do so.
The tool, called a segregated balance account, could be used to supplement the U.S. central bank's other mechanisms for raising rates, according to a paper released Friday and co-written by New York Fed Director of Research James McAndrews.
The proposal would reduce the Fed's need to transact directly with shadow lenders such as money-market mutual funds to soak up cash from the system and nudge rates higher. The paper expounds upon an idea discussed at the policy-setting Federal Open Market Committee's (FOMC's) October meeting as an option staff was exploring, minutes of the session show.
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At the following FOMC gathering in December, Fed staff suggested to policy makers that there were "questions about these accounts' possible effectiveness that would be difficult to resolve in a timely fashion," leading to a decision "that further work to implement such accounts would be shelved for now," according to the meeting minutes. The paper publicizes details of the plan and could fuel debate as officials get closer to their first rate rise since 2006.
The plan would heighten the role of banks in the transmission of monetary policy, which has changed dramatically since the 2007-2009 recession because of the nearly $3 trillion of excess reserves the central bank has injected into the financial system to stimulate the economy.
Negotiate Split
The segregated balance accounts, or SBAs, would allow overnight lenders of cash such as money funds to deposit money at a bank, which would in turn place the proceeds at the Fed and earn the overnight rate of interest that the central bank pays on excess reserves, known as IOER. The bank and the cash lender would negotiate how to split the interest, according to McAndrews and fellow authors Rodney Garratt and Antoine Martin of the New York Fed and Ed Nosal of the Chicago Fed.
This would ease the burden of the Fed having to transact directly with money funds through overnight reverse repurchase agreements, a tool the central bank has been testing to put a floor under short-term rates when it begins guiding them higher. Fed officials are wary of over-reliance on the reverse repo facility in part because it could starve the banks of funding in times of financial stress.
According to the model developed in the paper, smaller regional banks would "likely be able to attract all of the funds that go into SBAs," increasing their role in monetary policy transmission. That would mark a shift from the status quo, in which most reserves are held by large domestic banks and U.S. branches of foreign banks.
The report also suggests that by tying up reserves in SBAs instead of draining them from money funds directly through reverse repos, market rates "are likely to move closer to the IOER rate and be more tightly linked to that rate" than they would otherwise.
The paper identified key issues that would need to be resolved before SBAs could be used, including determining that the Fed has the authority to offer them, and securing cooperation of the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency in nailing down other legal aspects of the framework.
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