Back to the Future: The Fixed-Rate, Full-Allotment Overnight Reverse Repo Facility

Jan. 22, 2014 | By Global Liquidity

Fast forward five years. Let's imagine this hypothetical scenario: The era of quantitative easing is over. The Federal Reserve (Fed) completed tapering its asset purchases during the fourth quarter of 2014. The economy is growing at 4.5%, inflation is at 3.5%, unemployment is at 5.2% and the 10-year Treasury yield is at 4.5% as the US enters 2019. As the economy continues to grow, the Fed is trying to keep a lid on inflation. But the financial system is still awash with liquidity, and the Fed's balance sheets are still bloated due to its post-2008 aggressive bond-buying efforts. The newest monetary policy tool in the Fed's tool box is the fixed-rate, full-allotment overnight reverse repo facility, which was first mentioned almost six years ago.

What's in a name?

The concept of this new monetary tool with the very long name was introduced in the July 2013 minutes of the Federal Open Market Committee (FOMC) meeting. What would this facility do? William Dudley, president of the New York Fed, explains that it's all in name:1

  • Fixed rate. The Fed will supply an unlimited amount of Treasury and mortgage-backed security collateral to eligible counterparties at a fixed interest rate determined by the Fed.
  • Full allotment. There would be no cap on the amount of funds the Fed accepts from any of its counterparties.
  • Reverse repo. This denotes the direction the funds and securities move. In repurchase agreements, or repo, the Fed makes a collateralized loan to its counterparties, but users of this facility are making the economic equivalent of an overnight collateralized loan to the Fed.

Stated simply, the reverse repo facility, when fully developed, could serve as another important tool to help the Fed improve its ability to control short-term interest rates and the effectiveness of monetary policy. In this post-crisis era, an alternative became necessary because some of the Fed's traditional policy tools have fallen short in an economy where nonbank entities such as government-sponsored enterprises and money market funds play a larger role in the stability of the financial system and the transmission of monetary policy.

Limited effect of the IOER

The interest rate on excess reserves (IOER) — an instrument that pays banks for excess cash reserves parked at the Fed — is an example of a monetary policy strategy that had limited success. When the IOER was introduced in 2008, the Fed believed that paying interest on reserves would place a floor on the federal funds rate because depository institutions would have little incentive to lend in the overnight interbank federal funds market at rates below the IOER. The intent was to keep the federal funds rate closer to the FOMC's target rate than it would have been able to otherwise.2

However, in the years since, the effectiveness of the IOER in controlling short-term rates has been limited because only depository institutions — banks — are allowed to participate. In the meantime, other significant nonbank entities, such as the Federal Home Loan Banks, which cannot participate in the IOER, have had an incentive to lend in the fed funds market at a lower, but still positive, federal funds rate, consequently dragging down all other short-term rates.3 So while the IOER has been holding steady at 0.25%, the federal funds rate has been hovering around 0.08% to 0.09% during the six months ending Dec. 31, 2013 — not exactly the FOMC's target rate.4

This is why the new facility could be particularly useful to the Fed. It could help establish a stronger floor for overnight interest rates. This is significant both now — as the Fed attempts to calibrate its monetary policy amid efforts to taper its asset purchases — and for its long-term monetary policy objectives.

Testing of the facility underway

Since September, the Fed has been testing the facility with 139 counterparties while carefully calibrating the parameters. By most accounts, initial testing has been successful at setting a floor for overnight interest rates. In addition, the facility has helped drain an average daily volume of 0.2% of overall excess balances, though draining reserves is not the stated goal of the test.5 In October and November, daily participation was less than $4 billion across 12 counterparties, or $300 million per counterparty on average, well below the $1 billion limit set by the Fed.6

The force driving participation in the facility has been the spread between the fixed rate set in the facility and average interest rate on overnight Treasury repo. Participation in the facility is highest when the spread between the two rates is less than five basis points. Thus, the testing phase of the facility has also provided the Fed with invaluable insight about the sensitivity of investors to potential changes, specifically increases, in short-term rates.

The facility's testing period is scheduled to end on Jan. 29, 2014, but most market participants believe the testing period will be extended.

How could the reverse repo facility fit into Fed policy today?

Alongside louder market chatter about when the Fed would begin tapering its asset purchases, there's been a lower but persistent hum about the Fed cutting the IOER, including in the minutes of the October FOMC meeting, in Janet Yellen's confirmation hearing and in a Nov. 12 speech by Minneapolis Fed President Narayana Kocherlakota. This hum grew louder particularly as testing of the reverse repo facility got underway. Yet there's an overwhelming consensus among financial market observers that while the Fed could cut the IOER, it shouldn't, even with the reverse repo facility fully functional.

Why the Fed could cut the IOER
Two reasons Fed may cut the IOER include:

  • To reinforce "lower for longer." Market reaction following the taper announcement in December seemed to affirm that markets came to terms with the Fed's message that tapering does not equal tightening. However, as the yield on the benchmark 10-year bond continues to rise, hitting its highest level since July 2011 on Dec. 27, 2012,7 the Fed might feel compelled to back up its forward guidance about keeping interest rates low for longer with action — by cutting the IOER, for example.
  • To encourage banks to lend. With the IOER at 0.25%,8 banks have a convenient arbitrage opportunity — borrowing at the lower federal funds rate, then depositing their reserves at the Fed and pocketing the difference — instead of making loans. Lowering the IOER would reduce the incentive for the banks to park reserves at the Fed and potentially increase lending, which still lags, despite recent macroeconomic progress.

Why the Fed shouldn't cut the IOER
But the Fed shouldn't eliminate the IOER because doing so would potentially:

  • Wreak havoc in short-term markets. Cutting the IOER risks pushing already low interest rates on general collateral, T-bills and two- and five-year Treasury notes below zero, as significant cash moves into these markets. This could eventually result in severe disruptions for money market funds and for market liquidity more broadly.
  • Not encourage lending or economic activity. As Joseph Abate points out,9 the relationship between the interest rate on reserves and bank lending has historically been weak and still is. Financing is not the central motivation for banks increasing loan activity; rather it is the creditworthiness of borrowers, the return and their own capital levels.
  • Confuse the Fed's message. The reverse repo facility is a necessary but not sufficient reason for cutting the IOER. While the reverse repo facility could help establish a floor — preventing short-term rates from falling below zero — it runs the risk of confusing markets with these three simultaneous conflicting messages:
    1. The taper, which, while not a tightening, is a slowing down of stimulus.
    2. Cutting of the IOER, which is stimulus.
    3. The reverse repo facility, which is a tool for draining reserves (and tightening).

    With the Fed so intently focused on clear communication, this combination represents an unlikely trifecta.

Bottom line: While cutting the IOER is possible, we believe it's highly unlikely. So, putting aside the IOER discussion, what significance could the reverse repo facility carry in terms of monetary policy?

Back to the Future: Monetary Policy

In describing the reverse repo facility, Mr. Dudley emphasized that it should not be considered to be an element of the Fed's exit process. Maybe so. But as part of the soul-searching and research in the aftermath of its massive quantitative easing endeavors, the Fed is considering the tools at its disposal for managing rates and reserves going forward.10 The reverse repo facility is definitely one of the tools it is evaluating.

Several years from now, if inflation does pick up — in a scenario not too different from the one that opened this commentary — the Fed will need to mop up liquidity from the financial system. The reverse repo facility could be the cornerstone of the Fed's monetary policy in this environment — a facility that establishes a credible floor on short-term rates that applies to the variety of participants in these markets. That floor will be critical as the Fed attempts to raise rates.

So while it may not be part of an exit strategy or a prelude to a cut in the IOER, the reverse repo facility promises to be part of the Fed's long-term strategy in seeking to improve the delivery and efficacy of monetary policy in the future.

1 Source: Dudley, William C., "Reflections on the Economic Outlook and the Implications for Monetary Policy," from remarks at Fordham Wall Street Council, Fordham University Graduate School of Business, New York City Sept. 23, 2013

2 Source: Federal Reserve Bank of San Francisco, "Why did the Federal Reserve start paying interest on reserve balances held on deposit at the Fed? Does the Fed pay interest on required reserves, excess reserves, or both? What interest rate does the Fed pay?" March 2013

3 Source: Liberty Street Economics, Federal Reserve Bank of New York, "Who's Lending in the Fed Funds Market?" Gara Afonso, Alex Entz and Eric LeSueur, Dec. 2, 2013

4 Source: Bloomberg

5 Source: Barclays, US Weekly Money Market Update, Dec. 13, 2013

6 Source: Barclays, US Weekly Money Market Update, Nov. 8, 2013

7 Source: Bloomberg

8 Source: Federal Reserve, Dec. 31, 2013

9 Source: Barclays, US Weekly Money Market Update, Nov. 15, 2013

10 Federal Reserve Bank of New York. "Federal Reserve Tools for Managing Rates and Reserves." Staff Report No. 642. September 2013. http://www.newyorkfed .org/ research/staff_reports/sr642.pdf

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