WASHINGTON — The Federal Reserve Monday said it could soon test a program aimed at soaking up cash from the financial system, signaling Europe's debt woes aren't derailing the central bank's plans to unwind its huge stimulus.
The Fed authorized up to five small offerings of term deposits, in which banks set up interest-bearing deposits at the central bank, saying they could be tested as early as mid-June to familiarize banks with the process.
With the term deposit facility, banks would have an extra incentive to keep their money at the Fed instead of lending it out to companies and households, helping to prevent an outbreak of inflation once the economy gains speed.
As part of its efforts to fight the financial crisis and the ensuing recession, the Fed flooded the financial system with cash by buying assets. This led banks to accumulate $1.1 trillion in excess reserves, which are held at the Fed in overnight accounts. With the economy now on a more solid footing, the central bank is preparing to withdraw its emergency support, a first step towards tighter credit.
The Fed said in a statement the "offerings are a matter of prudent planning and have no implication for the near-term conduct of monetary policy." Still, the Fed's decision to go ahead with the liquidity-draining tool indicates its plans aren't being changed by Europe's debt woes.
The announcement came just hours after the Fed said it would revive a rescue program used during the financial crisis--through which it will provide foreign central banks, notably the European Central Bank, with dollar funding--which led some analysts to predict the Fed will tighten credit later than they had forecast.
The U.S. central bank has approved a basic structure for the small-value offerings. "Similar to many money market instruments, the term deposits offered will be simple fixed-rate instruments with maturities of 84 days or less and will be issued primarily through competitive single-price auctions," the Fed said.
The offerings will include a noncompetitive bidding option to ensure access to term deposits for smaller institutions. The term deposits are for lenders eligible to collect earnings on their balances at the Fed's Reserve Banks.
The New York Fed, which carries out monetary policy for the central bank by buying and selling securities, has already been testing tools to drain liquidity from banks by carrying out reverse-repurchase agreements, known as reverse repos.
In reverse repos, banks lock up money by borrowing against the Fed's large portfolio of securities holdings, thus constraining the supply of credit in short-term lending markets.
Fed Chairman Ben Bernanke said in February testimony that a possible sequence to tighter credit could start with the Fed draining the huge bank reserves via continued reverse repos and term-deposits, before scaling them up and increasing the interest paid on bank reserves.
