A recent paper from the Peterson Institute for International Economics “Monetary Policy with Abundant Liquidity: A New Operating Framework for the Federal Reserve” (January, 2014) is absolutely worth reading. The authors, Joseph E. Gagnon and Brian Sack, make an excellent argument for increasing the use of the Fed’s Reverse Repurchase (RRP) facility and synching the rate the Fed pays on reserves to the RRP.
The paper suggests a solution on how to manage the Fed’s a.) excess reserves balances and b.) securities portfolio.
“…we propose a new operating framework that will allow the Fed to conduct monetary policy while maintaining a substantially elevated balance sheet and abundant liquidity in the financial system. In particular, we believe the Fed should set the interest rate at which it will offer overnight repurchase agreements as its policy instrument and that it should maintain the interest rate paid on bank reserves at the same level. Under our proposal, all banks and many other financial institutions would have an unlimited ability to invest at the Fed at the specific interest rate. All other interest rates, including the federal funds rate, would be determined in the market, presumably with the risk-free interest rate set by the Fed exerting a powerful influence on them…”
“…By providing overnight RRPs in a full allotment facility, the Fed is effectively creating a financial market instrument that is nearly as liquid as reserves and that can be held by a broader set of financial market participants. In our view, it is important for the RRP and IOR rates to be set relatively close together to avoid giving an incentive for all of the liquidity in the financial system to remain in the banks (as it would if the IOR rate far exceeded the RRP rate) or to flow out of the banks (as it would if the IOR rate were well below the RRP rate)…”
The relationship between the IOER rate (25bp) and the Fed funds rate (closer to 7bp) has not made a lot of sense to us. But the alternative – letting IOER come down to near zero – was seen as worse. The consequences of zero or negative nominal interest rates include people stuffing cash into their mattress and all sorts of other anti-social behavior. The Fed would lose control of important policy levers.
Enter the RRP, a tool to take liquidity out of the system via a collateralized repo with a broad set of counterparties. The RRP can be used to set a floor to interest rates – sidestepping the problems of negative nominal rates. The Fed Funds market (which was benchmarked in the paper at $60 billion) is illiquid, especially in comparison to the $2 trillion repo market. Shifting monetary policy to a repo-based benchmark seems a win-win. But the missing piece was what to do about IOER. By pegging the IOER at the same level as RRPs, the implicit subsidy that banks receive from the above market IOER and other market inefficiencies could go away.
De-commissioning the Fed Funds market in favor of the RRP won’t be simple. The Fed Funds-linked OIS market is huge – a lot bigger than the underlying Fed Funds market liquidity would suggest it should be. Changing benchmarks on OIS-linked derivatives is reminiscent of the debate over moving away from LIBOR. It will take time and needs to be well thought out. But that time has come.
We would also point you to an excellent article by Cardiff Garcia in today’s FT Alphaville on this paper “A new call for rev-repo to become the new policy rate”. Unfortunately we can’t link to it because of the pay wall, but Cardiff makes some excellent points – including that one of the authors, Brian Sack, was head of the Fed’s Market desk until 2012.
A link the paper is here.