Corrects analyst affiliation in last paragraph

WASHINGTON (Reuters) - The Federal Reserve could take a first crack at draining liquidity from the financial system this summer as the economy shows signs of healing, an opening salvo for eventual interest rate hikes that could rattle still-fragile financial markets.

The Fed could begin draining bank reserves, via transactions known as reverse repurchase agreements, or repos, in large increments as early as this summer, market analysts say.

Importantly, the U.S. central bank could begin repos before it openly abdicates a commitment to keep interest rates low for an “extended period” since, technically speaking, reverse repos do not constitute an actual rate hike.

Repos would be a first step for the Fed to begin scrolling back on the extraordinary measures undertaken during the height of the financial crisis to support the economy. But they would not be without risks.

At the very least, the Fed may conduct fairly large tests of such transactions, known as reverse repurchase agreements, before it drops the “extended period” phrase on low rates from its policy statement, says William Dudley, president of the New York Fed, which oversees market operations. One such dry-run spooked markets back in October.

If the Fed launches a fresh round of vaguely defined tests, at a time where the market is already on edge about the possibility of higher borrowing costs, it might have much the same depressive effect on U.S. stocks and Treasury bonds, particularly since they would likely be interpreted as a sign of coming measures to tighten monetary policy.

“As of right now we’re looking for them to begin sometime in July,” said Omair Sharif, U.S. economist with RBS Securities in Stamford, Connecticut. “The big thing is going to be communication. They’re going to have to get out ahead of this one.”

In a reverse repo, the Fed temporarily removes funds from the financial system by borrowing the money from large primary dealer banks. In so doing, though, the Fed could unduly expose itself to the same risks as other investors in short-term money markets, according to some experts.

By forcing the central bank to rely on contracts with the private sector to conduct policy, reverse repos could compromise its independence, said Marvin Goodfriend, a professor of economics at Carnegie Mellon University.

“Reverse repos make the Fed dependent on contractual commitments of the private sector,” said Goodfriend, who is also a researcher with the National Bureau of Economic Research and recently testified before Congress on the subject of the Fed’s exit strategy.

“It’s a very good idea for the central bank to structure itself in a way to be immune from this.”

Reverse repos also expose monetary affairs to what traders like to call “event risk.” If any of the string of repos required to pull liquidity out of the system fails to find enough demand, for instance, investors might question the Fed’s ability to exit successfully from its extraordinarily stimulative stance, potentially stoking inflation and pushing market rates sharply higher.

JUMPY MARKETS

Naturally, expectations about when the Fed might pull the trigger on its first large-scale repos varies according to predictions about the direction of rates. But of the 13 primary dealers who responded to a Reuters poll earlier this month, six said they expected large-scale, non-test reverse repos to make their way to the market by summer.

Markets have already proven jittery at the mere intimation of higher rates, interpreting a rise in the discount rate charged for emergency loans as a baby step toward tightening and pushing borrowing costs higher accordingly.

The central bank has said it is working on ways to use some of the mortgage-backed debt it acquired during the financial crisis as collateral for reverse repos, which would be aimed at preventing excess liquidity in the markets from sparking inflation and, possibly, asset bubbles.

Estimates vary as to the frequency and size of such operations. The typical length is overnight, but they can be for as long as 65 business days.

“They will start small and get bigger,” said Bob Eisenbeis, chief monetary economist at Cumberland Advisors and former director of research at the Atlanta Fed. “I would expect to see upward pressure on Treasury rates -- another reason for starting slowly.”

A TRICKLE, NOT A FLOOD

So why are reverse repos needed? One way to think of them is as a safety blanket for policy makers, who by any measure are operating in uncharted territory.

Given the sheer enormity of excess bank reserves, which mushroomed from around $5 billion-$8 billion in the months leading up to the crisis to over $1.1 trillion at latest count, some Fed officials worry that the benchmark federal funds rate might not react to an increase in the interest on reserves.

“Policy makers want to loosen up the operating mechanisms on these newfangled levers before having to use them in earnest,” said T.J. Marta, chief strategist at Marta on the Markets.

This fear of the unknown has some foundation. Presumably, if the financial system is still flooded which cheap funding, simply saying that borrowing should be more costly might not be enough to deter banks from seeking lower rates. They might do so in either private markets or by tapping government-backed agencies like Fannie Mae and Freddie Mac, which are not allowed to receive interest on reserves, allowing them to sell mortgage-backed securities to investors at very low rates.

“The looseness of the reserve-effective funds relationship is more than just a market quirk,” said Joseph Abate, market strategist at Barclays Capital. “It poses serious questions about how aggressive the Federal Reserve will be once it starts draining reserves.”

And for the intricate machinery that is the modern system of reserve credit, the Fannie and Freddie have become an inconvenient cog.

“You can’t drain reserves and keep the effective funds rate constant,” said Thomas Lam, group chief economist with OSK-DMG. “The problem is that Freddie and Fannie are big suppliers of fed funds and they are largely responsible for the effective funds rate being below the rate paid on reserves.”