By Nick Timiraos 

With Federal Reserve officials likely to hold interest rates steady in coming months, the focus of their meeting this week shifts to fine-tuning their control of short-term rates.

The Fed successfully flooded markets with cash late last year to avoid a spike in overnight lending rates. Now, officials have to decide when and how to wind down the program. The task could be more complicated if some market commentators are right that the moves have fueled a stock-market rally.

At issue is an obscure but important corner of finance -- the market for repurchase agreements, or repos, in which banks and other firms borrow cash for short periods, pledging government securities as collateral.

Officials want to prevent volatility in the repo market from interfering with its control of the federal-funds rate, a benchmark that influences borrowing costs throughout the economy.

The Fed is likely to leave the rate unchanged Wednesday in a range between 1.5% and 1.75%.

Among the questions officials face: When and how fast to curtail the current expansion of the Fed's asset portfolio, which has swollen to $4.1 trillion from $3.8 trillion in September. And whether to start a new facility to cap money-market rates, and if so, how to design it.

Some officials have been hesitant to create a new facility, in which the Fed would lend in the repo market permanently, because they don't want too large a footprint in financial markets.

The latest problems materialized in September. Deposits by banks held at the Fed, called reserves, grew scarce enough to send the fed-funds rate upward unexpectedly. To prevent the cash crunch from leading to continued rate spikes, the Fed has been lending in the repo market daily.

Officials have been buying short-term Treasury bills since mid-October -- around $180 billion so far -- to permanently rebuild reserve balances in the banking system. They hope to retire these routine interventions in the next few months.

They expect to buy bills at least through April, May or June, but haven't indicated if or when they will slow from the current rate of $60 billion per month in purchases. The Fed is likely to buy a smaller amount of Treasury securities after that to keep up with the growth of other liabilities on its balance sheet, such as currency in circulation.

Fed Chairman Jerome Powell has emphasized that the purchases don't represent a return to the post-2008 stimulus programs, called quantitative easing or QE, in which the Fed purchased hundreds of billions of longer-term Treasury and mortgage securities in multiple rounds.

With QE, the Fed bought long-dated securities to reduce long-term interest rates to encourage borrowing, spending and investment. Fed officials say the current program is different because they are purchasing short-term bills that they believe provide little stimulus.

QE also had potentially powerful effects as a signaling device about the Fed's broader intentions to hold rates very low. This time, officials seek to avoid sending such a signal by saying repeatedly that the bill purchases are for technical and not economic reasons.

Nevertheless, some market commentators have tied steady stock-market gains since mid-October to the bill-purchase program. That, in turn, has prompted at least one Fed official to worry about investors pushing up stock prices because they are misreading the Fed's intentions.

"I believe very strongly we're going to need to find a way to curtail the growth in the balance sheet," said Dallas Fed President Robert Kaplan at a moderated discussion earlier this month. He has called the program a "derivative" of QE and worried the recent intervention was fueling "excesses and imbalances that may be hard to deal with later."

Most Fed officials haven't signaled the same concerns. Several have said their efforts to avoid a rate spike in late December suggest their tools are working effectively.

"Someone explain how swapping one short-term, risk-free instrument (reserves) for another short-term risk-free instrument (T-Bills) leads to equity repricing. I don't see it," said Minneapolis Fed President Neel Kashkari on Twitter. He instead pointed to a broader turnaround in the economic outlook that coincided with the Fed's three rate cuts last year.

Bill purchases may be less consequential than these broader developments, but they could have a marginal benefit. "You are making people feel much more confident about market functioning," said Seth Carpenter, chief U.S. economist at UBS Group.

It could be trickier for Fed officials to phase out the bill buying if investors believe the program is boosting asset prices.

Since the bill purchases were announced in mid-October, a constellation of data buoyed markets' confidence. They included stability in surveys of global manufacturing activity, stronger assurances from the Fed that it was unlikely to reverse last year's rate cuts anytime soon and fewer risks of a U.S.-China trade war or a messy British exit from the European Union.

"Bill purchases wouldn't have put the stock market where it is right now in the absence of objectively good news, but the risk the Fed faces is the good news may not last forever," said Lou Crandall, chief economist at research firm Wrightson ICAP.

Spelling out the ultimate destination for the balance sheet and reserve levels now, he said, could help avoid a backlash later, particularly if the global economic outlook dims. "You want to have signaled the timing of the pullback and the reasons for it well in advance -- before the weather turns," said Mr. Crandall.

Write to Nick Timiraos at nick.timiraos@wsj.com

(END) Dow Jones Newswires

January 28, 2020 05:44 ET (10:44 GMT)

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