Fed Effective Twitches Higher as Fed Increases Rev Repo Rate

Refresher: The Fed's reverse repo program is a secured lending program. That means that the Fed borrows money from counterparties - primarily money market funds, banks and the GSEs - and the Fed lends (collateralizes the loan) with Treasury securities. This drains cash from the financial system for the term of the loan (overnight). Another way to think of this is that money market funds, banks and the GSEs normally have large piles of cash. That cash can either sit on their balance sheet earning nothing, or they can invest it. One option for investing it overnight is at the Fed - fully collateralized in exchange for Treasuries - and earn the reverse repo rate set by the Fed, which for most of the past year has been 5 bp. Which beats investing in similar maturity T-bills and has less credit risk than, say, unsecured overnight commercial paper.

Victory for the Fed! The open market operations group at the NY Fed must be high fiving each other right about now. And deservedly so. As previously announced, they raised the rate for the Fed's reverse repo program (RRP) from 3 to 7 basis points this week - a new high for the program since its inception in September of last year - and the Fed effective (the average daily Fed funds rate) rose right along with it, from 9 to 11 bp. Not surprisingly, the higher RRP rate attracted more bidders for the Treasury collateral - with yesterday's bids rising to $167 bn from last week's average of $100 bn per day.

Sidebar: The drop from 5 bp to 3 bp  last week was also a "test drop". Just ignore it and assume the previous rate was 5 bp where it had been held since early in 2014.

Next raise coming in December. The Fed will keep the RRP rate at 7 bp through the end of this month, then raise it again to 10 bp for the first two weeks of December. That should push the Fed effective up to 14 bp and increase the "intraday low" bid for Fed funds (shown on the graph in orange) to 10 bp, which has so far followed the RRP rate almost in lock-step.

What's the point of all this? The Fed is trying to establish whether or not the rate offered in the RRP can function as a lower bound for other short term rates - in particular the Fed funds rate - when it begins to raise rates sometime next year. The Fed became sharply aware post-crisis that the Fed funds market is thin and dominated by non-bank lenders. The Fed effective needs to have a new, more reliable fixing process (which is being discussed) or the Fed needs to migrate away from using it as their benchmark rate of monetary policy (also being discussed, though the FOMC is not quite admitting to that now).

Impact on other lending rates. Treasury general collateral repo rates outside the RPP have been pushed higher of late, so they did not clearly rise from the Fed's increase to 7 bp, but it will be interesting to see if they do follow suit higher in December.