The tool -- known as a fixed-rate full-allotment reverse repo facility -- "offers a promising new technological advance" for conducting policy, Simon Potter, who runs the New York Fed's market operations, said in remarks to bond traders.
Potter's full-throated backing of the facility could pave the way for full adoption by the Federal Reserve. The speech comes nearly three months after Fed policymakers decided to start testing it as a way to better control short-term interest rates when the time comes to raise the key federal funds rate.
The U.S. central bank has kept the federal funds rate near zero since late 2008 to help the economy recover from recession and has promised to keep it there for a while longer, probably until 2015. Since banks are sitting on so much pent-up reserves, there is a fear that a policy tightening will spark chaos in so-called repo markets.
The proposed tool is designed to mop up excess cash in the financial system, which if left unchecked could keep rates lower than perhaps desired by the Fed at a later date. Potter's staffers at the New York Fed have been testing the facility since late September, though the central bank has not formally backed it.
Used together with a rate on excess bank reserves, Potter said, the new tool "may strengthen the floor for short-term interest rates and, with it, the Federal Reserve's control of money market rates, by surmounting the competitive and balance sheet frictions seen in money markets and by extending the central bank's payment of interest to a wider universe of relevant counterparties."
It could also allow for "a more robust and effective implementation of the FOMC's policy directives both during the rate normalization period and when there is a very large balance sheet," he said at a Money Marketeers of New York University event.
In reverse repurchase agreements, or reverse repos, the Fed temporarily drains cash from the financial system by borrowing funds overnight from banks, large money market mutual funds and others, and offering them Treasury securities as collateral. Banks and the funds receive the modest overnight interest rate.
The facility would effectively expand the Fed's reverse-repo counterparties beyond the 139 funds, dealers and government-sponsored enterprises it deals with now.
The New York Fed, which is responsible for carrying out the central bank's $85 billion monthly bond-buying program, has increasingly raised the rate on the test facility from 0.01 percent when it was launched to 0.05 percent now. The federal funds effective rate is around 0.09 percent.
In each of the test operations, total usage of the facility has ranged from $345 million to $58 billion, while the number of bidders has ranged from four to 87, Potter said. Daily bids average $4.5 billion from 17 bidders, excluding those at the end of months of quarters, he added.
Those involved in the test have called it "smooth with minimal disruptions," Potter said in praising the facility. They "expect that a facility, if executed in full scale in the future, should be an effective tool for increasing the Fed's control of short-term money market rates through a stronger floor," he added.
The policy-setting Federal Open Market Committee has authorized the test to run through January 29 - the date Ben Bernanke is to step down as Fed chairman.