William C. Dudley, President of the New York Fed, gave a speech on May 20th to the New York Association for Business Economics called “The Economic Outlook and Implications for Monetary Policy”. He said some interesting things about the Fed’s Reverse Repo facility (RRP).
The Fed has been happy with the use of the RRP to control short rates. This used to be the role of the Fed Funds market, but IOER has made it irrelevant.
“…Early results suggest that the overnight RRP facility will set a floor under money market rates. Treasury repo rates have generally traded no more than a basis point or two below the overnight RRP rate. Thus, the early evidence suggests that this facility would help strengthen our control over money market rates…”
But the program is not without its issues. They don’t want RRP rates to be very close to IOER levels, fearing a shift of funds out of banks into money market funds. The MMFs are considered part of shadow banking and the Fed doesn’t want to add fuel to that fire.
“…Two issues with the overnight reverse repo rate warrant careful consideration. The first is how big a footprint the facility should have in terms of volume. To the extent that the overnight RRP rate were set very close or equal to the interest rate on excess reserves (IOER) without caps, then this might result in a large amount of disintermediation out of banks through money market funds and other financial intermediaries into the facility. This could encourage further development of the shadow banking system. If this were deemed undesirable, this would argue for a wider spread between the overnight RRP and the IOER in order to reduce the volume of flows into the facility…”
The Fed worries about the RRP program’s impact on financial stability. In a stress environment, will RRP help or hinder? One issue during the financial crisis was the available of “safe assets” that were not subject to bank run risk. Certainly RRP would be an imporovement.
“…The overnight RRP facility allows us to make a short-term safe asset more widely available to a broad range of financial market participants. The provision of short-term safe assets by the official sector might crowd out the private creation of runnable money-like liquid assets. This might enhance financial stability by reducing the likelihood of a financial crisis…”
But the ease of transition into a safe asset like RRP means markets might be a little more fluid than would be ideal. Does the Fed want to make sure there is some friction slowing things down when the heat is turned up?
“…However, if a financial crisis were to occur, the existence of a full allotment, overnight, RRP facility might exacerbate instability by encouraging runs out of more risky assets into the facility. That is because the supply of a full allotment facility would be completely elastic at the given fixed rate. Money market mutual funds and other providers of short-term financing could rapidly shift funds into the facility away from assets such as commercial paper that support the private sector…”
“…Consequently, under a full allotment setup, runs could be larger and these runs could exacerbate the fall in the prices of riskier assets. Note that the risk here is how quickly financial flows could reverse from one day to the next, not the average level of take-up of the facility over time…”
But the Fed has a solution, although not one anyone is going to like. They will take the punchbowl away just as the party starts.
“…Fortunately, this risk seems relatively easy to address. One could design the facility to prevent rapid inflows during times of financial stress. This could be done by building in circuit breakers such as caps on overall usage of the facility. The circuit breakers would not affect the amount of take-up during normal times or prevent take-up from rising at moderate rates. Instead, they would be in place to limit the pace and magnitude of inflows during times of stress…”
An alternative to RRP might be an increased use of term deposits. The Fed has been testing those out recently too. But it seems like second choice and is more expensive for the Fed.
“…A second option to improve the Fed’s control over short-term rates is to drain reserves by offering banks term deposit accounts in which to invest funds for longer terms than overnight. There are two issues that might make this option somewhat less attractive. First, to strengthen monetary policy control significantly through this course, it might be necessary to drain most of the $3 trillion of reserves. This could be done of course with effort, but is the effort worth it?”
“…Second, the Fed would undoubtedly have to “pay up” to induce banks to hold term deposit accounts relative to keeping their monies in reserves at the excess reserves interest rate. This would likely result in higher Fed interest expenses relative to relying on an overnight RRP facility to set a floor on money market rates…”
The RRP is here to stay and it sounds like it will be the policy tool of choice. It will be tricky to manage the relationship between RRP and IOER. We see the point about wanting to keep cash from being sucked out of banks and into the money market funds – but the shadow bank rationale seems a stretch and the banks are getting a generous taxpayer funded subsidy in IOER.