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Fed may have to take steps to keep key interest rate stable

The central bank injected billions of dollars into the banking system in September

Photo (c) Toshe_O - Getty Images
After having to inject billions of dollars into the short term money market -- the so-called repo market -- the Federal Reserve may be moving toward a more permanent solution to stabilize that capital markets.

In an interview with The New York Times, John Williams, president of the New York Federal Reserve Bank, said the Fed might contemplate an ongoing program for overnight repos, to prevent shortfalls in the future.

Throughout September, the New York Fed has stepped in to pump more cash into the overnight market to keep the federal funds rate at the target range of 1.75 percent to 2 percent. Because of a shortage of money from major banks, the rate shot up to 10 percent earlier this month. That not only posed a threat to the bond market but to the overall banking system.

More troubling perhaps, it was the first time this issue had arisen since 2008, just before the financial crisis.

The need for the first injection of capital was blamed on a one-off situation -- major corporations needing to make quarterly tax payments. Since then, however, the Fed had acted again to put more cash into the system.

Permanent program

Williams says the Fed might consider putting in place a permanent program for overnight repurchase agreements, or repos, to avoid such risks in the future. 

"We are seeing that liquidity doesn't move around as easily in these situations, which means that if we want interest rates to stay kind of on their own in a narrow range, that we have to make sure we have that amount of reserves to support that," Williams told The Times.

What’s concerning is the fact that banks have experienced a shortage of money for short-term, overnight loans. After the financial reforms enacted after the financial crisis banks are required to maintain larger cash reserves.

But some analysts have said banks have the option of keeping those reserves invested with the Federal Reserve earning interest and have found that to be a better business than loaning it out.

For the Fed, the issue is one of control. After setting the target federal funds rate at between 1.75 percent and 2 percent it can’t afford to have the market send that rate sharply higher.

The policy-making branch of the Fed -- the Open Market Committee -- set the federal funds rate at between 1.75 percent and 2 percent in late September and has since been forced to take extraordinary steps to keep it there.

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