Higher repo rates could be the mechanism through which the reserve demand curve shifts upward. Through this mechanism, authorities could see higher federal funds rates even if the aggregate quantity of reserves remains within recent ranges, said Roberto Perli, manager of the System Open Market Account at the New York Federal Reserve in a recent speech.
If the effective federal funds rate (EFFR) moves up and gets close enough to the interest rate on reserve balances (IORB), foreign banks — which are the largest borrowers of federal funds, primarily to earn the spread between EFFR and IORB — may pull back from that market. At that point, the size and structure of the federal funds market could change, leaving mostly rate-sensitive domestic banks as borrowers. That could increase EFFR volatility, while potentially leading to a downward sloping demand curve for reserves and making the market more susceptible to hard-to-predict shocks.
If all that happens, indicators would join the repo market indicator and start pointing to tighter reserve conditions as well. For example, the share of domestic banks borrowing in the federal funds market would go up mechanically, and other indicators may also move over time.
“For now, pressures in the repo market don’t appear to be close to the point where they would start affecting the federal funds rate. For that reason, I believe there is plenty of room to continue shrinking the SOMA portfolio. Still, in 2018, the repo market arguably served as a leading indicator of pressures developing in the reserves market. There is no guarantee that it will be the same again this time, but my colleagues and I will be monitoring its evolution,” he said.