Bravo to the Fed: the Repo Test is Working

Background: The previous post, Litmus Test for Monetary Policy Started Monday, reviews the rationale of the Fed's ongoing test of "just barely" raising the reverse repo program (RRP) rate to assess the impact on the front end of the curve.

Success: Other short term rates have risen in tandem this week with the Fed's upward pressure on RRP from 7 to 10 bp (see chart below). The Fed effective has notched from 9 bp to 12 bp; the general collateral Treasury repo rate has stayed elevated at ~20 bp; and perhaps most importantly, AA financial, non-financial and asset backed commercial paper rates have edged up from 3 to 7 bp to 9 to 12 bp (not shown on chart, data available here). This provides modest but important confidence that - when the Fed does begin to tighten policy sometime next year - raising the RRP rate will likely function as an effective transmission mechanism to other short-term secured and unsecured lending rates.

Volatility in the Fed effective still likely but tolerable: One thing the Fed has not done is push the RRP rate high enough to fully induce the lowest bid cash lenders (some of the FHLBanks) to move all of their lending away from the Fed funds market. You can see in the second chart above the intraday high and low bids (the gray and orange lines) plotted with the Fed effective, which is the volume weighted average rate. The only way that the daily average can be that low - that close to the lower bound - is if the distribution is highly skewed towards the lowest lending rates. The worry - or eventual expectation, really - is that if the FHLBs were to significantly or completely reduce lending in the Fed funds market in favor of RRP or CP or another higher, short-term market, then it would push the Fed effective to set materially higher towards the intraday high of ~31 bp. That's actually not a big deal in reality, as the number of institutions that borrow in the intrabank market is very low, and functionally it changes nothing to have the fed effective rate reset without the presence of the FHLBs. Optically it would of course be shocking to those who don't follow this market closely (that is, practically everyone) but after a period of volatility, the Fed could no doubt convince the market to maintain its focus on the RRP and the interest on excess reserves (IOER) rates as opposed to the Fed effective.

Next steps - determining the spread between RRP and IOER: The Fed is maintaining the RRP rate at 10 bp through the end of next week, then is expected to drop it back down to 5 bp. I suspect the Fed will arrange another test early next year where it raises the RRP rate to 15 or 17 bp for a short period of time. This would give the Fed some information - to back up a lot of untested theory and educated modeling (guessing) by Fed researchers - of what may be a "normal," maintainable spread of RRP to IOER. Although it can seem pedantic, setting a “normal” spread between the two rates is more than an academic exercise. The RRP rate is a collateralized lending rate where – at least for now – mostly money market funds lend money to the Fed on a secured basis in exchange for Treasuries. This is the shadow banking system lending to the safest counterparty on the planet. The IOER rate is the Fed paying interest on cash reserves in the banking system - which it created through 3+ rounds of quantitative easing - to the depository institutions that hold those reserves. The Fed needs the secured lending rate in the shadow banking system to influence, but not be pari passu with, the unsecured interest / lending rate in the banking system. And for both of these avenues to effectively transmit the tightening policy throughout the market.

Guesses are that the two rates should be held anywhere from 5 to 20 bp apart. With the IOER currently at 25 bp, and it becoming the de facto "fed target rate" through the next tightening cycle, that would mean the Fed would set the RRP rate anywhere from 5 bp - where it is currently - to as high as 20 bp, as a lower bound before the FOMC begins to tighten monetary policy.

What could go wrong? The answer that almost everyone will give you is that inflation could ignite since the Fed will eventually be trying to tighten policy without draining the $2.7 trillion of extra liquidity in the banking system. The Fed will tell you that they can successfully tame any unwanted inflation by raising IOER rapidly, which discourages banks from lending money / providing easy credit at rates below where they can safely earn interest on those reserves. All of that is true, but not what worries me.

The Fed’s reverse repo program has now grown to about $150 bn in size. That is, each day the Fed takes in roughly $150 bn of cash from various lenders, predominantly money market funds, in exchange for $150 bn of Treasury collateral. At current operating size the RRP is now larger in total par value than the general collateral Treasury repo market as cleared each day at the Fixed Income Clearing Corporation (FICC) (chart above).  The Fed has recently capped the size of the RRP operations to $300 bn. Given the path the Fed has chosen, this was probably an inevitable necessary step, but it is contrary to their stated role of being the “lender of last resort”. Instead of influencing short-term rates, the Fed has now inserted itself as a major participant and provider of collateral into the short-term markets. Eventually there will be another financial crisis. Hopefully it will occur long after the Fed has stepped back from these large-scale operations, allowing them to successfully intervene as necessary and function in the role of liquidity backstop and not “liquidity market maker”.