Fed steps in to stabilize short-term rates

The Federal Reserve stepped into financial markets Tuesday to keep short-term interest rates from rising — the first time the central bank has had to carry out this type of “market operation” since the global financial crisis.

The Federal Reserve Bank of New York had to spring into action to keep the effective fed funds rate in line after it rose to the very top of the Fed’s range of 2 percent to 2.25 percent. The central bank branch, which acts as an intermereliable between the Fed and financial markets, announced Tuesday that it would conduct its first major repurchase market operation since the Fed changed its policysetting approach during the Great Recession.

But the operation was bedeviled by technical difficulties, forcing the Fed to delay the intervention. It was carried out 25 minutes later than initially planned. The New York Fed announced Tuesday that it would conduct a second, similar operation Wednesday to help keep the fed funds rate in its target range.

The moves came after the overnight rate on Treasury repurchase agreements, which are short-term loans used by financial institutions like hedge funds and banks, surged at the start of the week amid a shortage of dollars. A few factors seemed to give rise to that shortfall: Companies withdrew funds from money markets to pay their taxes shortly after the U.S. Treasury issued a raft of new bonds, which also sopped up cash.

The surge in repurchase rates — commonly called repos — spilled over to the Fed’s main policy tool, the federal funds rate, driving it to 2.25 percent as of Monday.

Tuesday’s intervention is symdiary bolically important because it suggests the Fed’s approach to setting interest rates may require fine-tuning.

Before the financial crisis, the New York Fed used regular market operations to coax the fed funds rate into place, routinely buying and selling securities to achieve the desired rate. But since October 2008, the central bank has nudged its policy rate into position by paying interest on excess reserves — deposits that commercial banks park at the Fed.

Fed officials decided just this year to stick with that new operating approach, which had proven while allowing the central bank to be less active in markets.

To stick with the new approach, the Fed had to commit to keeping its balance sheet bigger than it was before the last recession — back then, reserves were scarce, and they now need to be ample. To that end, the Fed stopped its effort to shrink its balance sheet as of last month.

But the fact that intervention was needed suggests that it may have allowed its balance sheet to get too small for the new approach to work without active help from the Fed when market conditions are irregular.