Fed confident about smooth US rate hike despite uncertainty about how investors will react

NEW YORK (Reuters) - The Federal Reserve is confident it can smoothly lift interest rates when the time comes, though it stands ready to make adjustments on the fly given uncertainty about how investors could react, the Fed official responsible for market operations said on Wednesday.

The New York Fed's Simon Potter, who leads the team that will be responsible for hiking rates after more than six years at rock bottom, said questions remain over how much investors will use a new and lightly tested tool meant to help the central bank tighten monetary policy.

The tool, an overnight reverse repurchase facility, or ON RRP, is meant to help mop up the trillions of dollars in excess reserves lingering in short-term markets after the financial crisis and years of subsequent Fed easing.

Mr Potter warned against an over-reliance on ON RRP could lead to financial instabilities, and said months of testing has shown that the Fed probably will not need to make the facility unlimited in order to maintain control over short-term rates.

"Our testing programme gives us confidence that we have the necessary tools to enable a smooth lift-off," he told the Money Marketeers group of bond traders, adding the Fed aims to raise the cap on the repo facility to a level that the investors deem sufficient to ensure a smooth "lift-off." The highly technical speech amounted to more confident talk from the central bank as it approaches a tightening likely later this year.

The market for the Fed's traditional policy rate, federal funds, is a fraction of its pre-crisis size. So policymakers will rely on an array of rates including ON RRP, interest on excess bank reserves (IOER), and term repos and deposit facilities, to smooth things over.

The New York Fed will be under intense global scrutiny as it approaches a rate hike, given it last raised rates in 2006.

The Fed "will be particularly careful at the start because demonstrating appropriate control over the federal funds rate and other short-term rates is a priority," Mr Potter said. "Demand for ON RRPs following liftoff could remain relatively steady," he added. "But it could conceivably be much greater than what we have seen at higher levels of interest rates or as regulatory and structural changes in money markets boost demand for safe assets.

In a reverse repo, the Fed pays bidders a rate to borrow bonds with the promise of selling them back after a short period, allowing it to lift yields across the overnight markets.

When it is time to reduce use of the ON RRP, Mr Potter said the Fed was prepared to adjust the spread between it and the higher IOER, set caps for investors, and run auctions.

He said it could be reduced "fairly soon" after the rate hike, and follow a "natural glide path" that parallels a planned run-off in the Fed's $4.5-trillion portfolio of assets.