No sooner will the Federal Reserve raise US interest rates than it must make more decisions on how to drain markets awash in cash and, further down the road, how to shrink its swollen balance sheet.

The US central bank is widely expected on Wednesday to hike its key federal funds rate by a modest 0.25 per cent. It would be the first tightening in more than nine years and a big step on the tricky path of returning monetary policy to a more normal footing after aggressive bond-buying and near-zero borrowing costs.

The New York Fed, which handles the mechanics of monetary policy three blocks from Wall Street, will turn on Thursday to a suite of lightly tested tools to drive rates higher.

It will be far more difficult than in the past.

Years of unprecedented stimulus has left the Fed swollen with $4.5 trillion in bonds, and the banks bursting with $2.6 trillion in reserves. All this liquidity has eclipsed the effectiveness of the Fed funds market as the central bank’s primary policy lever.

So the Fed will seek to raise rates to the new range of 0.25 to 0.5 per cent by setting a floor and a ceiling with other levers that may need to be adjusted on the fly, depending on the reaction of markets.

Questions remain on how aggressively the Fed will rely on these tools and, later, when and how much it will shrink its portfolio.

Heavy lift

The 0.25-percent floor will be the rate on an overnight reverse repurchase program, or repo, which the central bank has been testing for more than two years but not relied upon for policy. The Fed is expected to double its current $300-billion cap or even make the program unlimited to ensure that borrowing is more expensive.

The nightmare scenario is that rates in short-term markets simply don’t rise enough and force central bankers to aggressively lean on reverse repos, in which the Fed pays a rate to bidders who park cash for a short period at the central bank.

The 0.5-percent ceiling is interest the Fed pays banks on excess reserves, seen as the primary tool. The Fed can also turn to term repo and deposit facilities as needed.

A smooth liftoff will be up to a team of traders in the New York Fed’s “operations room,” who on Thursday morning will closely monitor key short-term rates to determine whether markets are cooperating. They will also run the repo auction between 5.45pm and 6.15pm with banks, government-sponsored entities and some 130 money funds that do not usually do direct business with the Fed.

Slimming down

Likely after a few rate hikes are out of the way next year, the Fed will have to decide how to drain its portfolio of treasury and mortgage bonds, either by allowing them to run off naturally or by selling outright. For now it is topping up the balance sheet as assets mature.

Some policymakers and outside experts are also saying the Fed could choose to keep the portfolio big in order to stabilize financial markets and to provide an additional policy tool to target sectors of the economy or bond market.

Former Fed Chairman Ben Bernanke said last month that leaving the balance sheet as is "wouldn't be a problem."

- Reuters