Federal Reserve to test term deposit facility

Federal Reserve to test term deposit facility
By James Politi in Washington
Copyright The Financial Times Limited 2010
Published: May 11 2010 00:06 | Last updated: May 11 2010 00:06
http://www.ft.com/cms/s/0/9e4ebee0-5c86-11df-bb38-00144feab49a.html


The Federal Reserve said on Monday it would begin testing its “term deposit facility” – a tool to drain liquidity from the US financial system – as early as mid-June.

Fed officials have made clear that the move to press ahead with term deposits should not be considered a sign that it will soon begin raising interest rates.

However, the board’s approval for the measure shows that the European sovereign debt crisis has not affected the Fed’s plans to prepare for a tightening of monetary policy once the economy is strong enough.

Term deposits are designed to work for banks in a similar way that certificates of deposit work for individual consumers. During the testing period, the Fed will make five small term deposit offerings with maturities of up to 84 days.

Once the tool is ramped up to a larger scale, its purpose is to provide an incentive for banks to hold money at the central bank instead of lending it. That would help shrink the Fed’s balance sheet from its current size above $2,300bn to below $1,000bn, or close to its pre-financial crisis level. The Fed has already tested so-called “reverse repurchase agreements” as another tool it intends to use to drain liquidity from the financial system – most probably shortly before it raises interest rates.

How the Fed will execute an “exit strategy” from the extraordinary measures it put in force to prevent the collapse of the US economy in 2008 has been high on the central bank’s agenda this year. However, officials still maintain that “exceptionally low” interest rates would remain in place for an “extended period” – a sign of caution about the strength of the US recovery.

As the European sovereign debt crisis intensified in recent weeks there has also been growing concern within the Fed about the potential negative impact on the US economy. Those worries were so acute that the Fed on Sunday night agreed to reopen its crisis-era tool box by signing off on a programme of currency swaps with foreign central banks, primarily to make it easier for struggling European banks to gain access to dollar denominated funding.

Economists at Morgan Stan ley cited Eur ope’s turmoil as the reason for altering their prediction on the timing of the first US interest rate increase from September to the beginning of 2011. “The European sovereign credit crisis, its threat of contagion beyond Eur ope, and its effect on inflation expectations is the key reason for these significant changes,” the bank said.