The New York Fed quietly announced it is testing a “new tool” that would provide a lifeline for yield-starved money market funds.

In a speech today at Fordham University, William C. Dudley, president and chief executive officer of the New York Fed, said the Fed was developing a fixed-rate, full allotment overnight reverse repo facility. The Fed would open this facility to money market funds and other financial institutions — not just to the primary dealers through which it historically has conducted its open market operations.

That is, the Fed would offer a fixed interest rate to repo counterparties) including banks, dealers, money market funds and some government sponsored entities) on money that they lend to the Fed.

The Fed terms these transactions “reverse repos,” or reverse repurchase agreements.  Under this definition, the Fed sells an overnight security to a money market fund (or other counterparty), which in turn pays a purchase price.  The following day, the Fed repays the loan (and gets its securities back).  The repayment amount is higher than the purchase price: the difference is, in effect, an interest payment.  The transaction is the economic equivalent of an overnight collateralized loan of cash to the Fed.   (The Fed characterized these transactions from its own perspective.  From a money market fund’s perspective, these transactions would be “repos.”)

The Fed also terms the facility “full allotment” — that is, the facility would have no cap on the amount of funds accepted from any of its counterparties at the posted overnight interest rate.

The reverse repo program effectively would establish a floor on money market rates, thereby improving the Fed’s control over short-term interest rates.  This is because by offering what is essentially a risk-free investment, a counterparty would be unwilling to lend money to a borrower for a smaller return, especially when the loan would involve some degree of risk.

Dudley made it clear what the program is not: “The testing and development of the facility is not being undertaken to facilitate or expedite exit from our large balance sheet and should not be considered to be an element of the exit process,” he said. In addition to setting a floor on money market rates, the program is designed “to improve the implementation of monetary policy even when the balance sheet is large.  Even if our balance sheet increases significantly further and stays very large for many years, it will be useful to have this facility available to improve monetary policy control.”