WASHINGTON (Reuters) - Stress in U.S. money markets loomed over a Federal Reserve policy meeting on Wednesday with new data showing that the central bank’s target interest rate had drifted outside the level set by the central bank for the first time since the 2007-2009 financial crisis.

The move came even as the New York Fed intervened in markets to keep the federal funds rate in line, and as officials met to discuss a likely quarter of a point interest rate cut.

Data released on Wednesday showed the effective federal funds rate rose to 2.3% on Tuesday, outside the range of 2% to 2.25% established at the Fed’s last meeting.

While this week’s meeting is expected to end with a quarter point rate cut and discussion of whether more cuts are to come, the session may now be dominated by debate at the Fed and in markets about whether the central bank has full control over the underlying policy interest rate it uses to influence financial conditions in the United States and globally.

The meeting already presented the Fed with a conflicting mix of economic data and steady pressure from President Donald Trump for deep interest rate cuts.

But the outbreak of financial tension put a new set of issues in play, prompting the New York Fed on Tuesday and Wednesday to pump up to $150 billion into the U.S. money market after the costs for securing overnight repurchase agreements spiked. Those agreements are a key feature of U.S. financial markets, and their cost a key barometer of whether short-term markets are functioning well.

While the rise in repo rates was attributed to seasonal cash flow issues and other more technical factors, the episode was reminiscent of the market strains that prefigured the financial crisis a decade ago.

Still, with policymakers meeting this week, it cast an untimely light on the Fed’s sometimes rocky transition to a new system for managing interest rates and on debate over the appropriate size of its $3.8 trillion balance sheet.

SIGNIFICANT DIVISIONS

The Fed was already working through significant divisions about whether a reduction in borrowing costs is needed, though policymakers are expected on Wednesday to cut the key overnight lending rate by a quarter of a percentage point for the second time this year.

The Fed is due to release its policy statement at 2 p.m. EDT (1800 GMT). Fed Chair Jerome Powell is scheduled to hold a news conference half an hour later.

A rate cut on Wednesday would lower the Fed’s target policy rate to a range of between 1.75% and 2.00% and dovetail with moves by central banks around the world to ease monetary policy to offset the impact of a U.S.-China trade war and other risks to the global economy.

From world bond markets to Trump, however, the more consequential reaction may come in response to how the Fed describes its latest policy decision, the expectations it sets for possible rate cuts later this year and in 2020, and, in light of market developments, whether the central bank shifts gears and begins to again expand its asset holdings or changes it tools for managing rates.

The Fed has discussed, for example, setting up a standing “repo” offering of its own to avoid the sort of stress that emerged on Tuesday.

Analysts also said this may prompt the Fed to begin expanding its balance sheet to make sure there are adequate reserves in the system to avoid the sort of liquidity shortages that appeared this week.

“The Fed absolutely lost control over the fed funds rate,” said Gennadiy Goldberg, senior rates strategist at TD Securities, noting that the 2.3% effective rate reflected Tuesday’s blow-up in the repo market, and adding that the New York Fed’s measures since then, including its liquidity injection Wednesday, have probably brought the rate back into line.

“This is one of the signs that they should reverse course on the balance sheet,” and begin to increase it, said Steven Ricchiuto, chief U.S. economist at Mizuho Securities. “They recognize that they have a bit of a problem.”

FILE PHOTO: U.S. Federal Reserve Chairman Jerome Powell speaks at a panel discussion at the University of Zurich in Zurich, Switzerland September 6, 2019. REUTERS/Arnd Wiegmann/File Photo

The Fed may also make another adjustment in the gap between its target rate and the interest it pays banks on excess reserves, a tool it uses to encourage or discourage banks from holding cash at the central bank.

COMPLEX ISSUES

The Fed has allowed the size of its balance sheet to decrease as part of its effort to unwind the policies put in place to fight the 2007-2009 recession.

While a highly technical issue, the Fed’s balance sheet policy also has broader economic significance, and can influence rates of long-term bonds and other securities as it chooses to buy and sell securities. Even if the Fed only allows the balance sheet to expand to meet the public’s demand for cash and satisfy banks’ apparently larger-than-expected demand for reserves, it could at the margin ease financial conditions.

A rate cut would be intended to do the same, as the Fed reacts to an array of issues that have forced it to pivot since the start of the year from a stance in which it expected to continue raising rates this year to one in which it is cutting them.

The question that policymakers will answer in their statement, through updated economic projections, and in Powell’s news conference, is how much more help they feel the economy needs considering that U.S. unemployment is low and growth remains steady.

The answer will hinge in part on how the Fed is assessing geopolitical events well outside its control. The on-again, off-again U.S.-China trade war, for example, has given policymakers little clarity about what to expect next. The attacks that crippled Saudi Arabian oil facilities over the weekend, which led to a sharp rise in oil prices, only emphasized the point.

Powell and his colleagues have reduced that complex set of issues to a manageable phrase, saying after their July meeting that they would “continue to monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion.”

Given the volatile events of the last few weeks, they are apt to hold onto it.