Litmus Test for Monetary Policy Started Monday

What if the Fed raised rates and the market didn't respond? Today through year-end is when the Fed and the market will get its first inkling of whether or not the Fed can successfully pressure short-term rates higher without draining $2.7 trillion of excess reserves in the banking system. This is a big deal. This is the first real test of whether or not raising the reverse repo program (RRP) rate will potentially be an effective conduit of monetary policy.

The test. As of Monday, the Fed raised the overnight reverse repo rate to 10 bp, and will leave it there through mid-December. That means the Fed is willing to pay interest of 10 bps to investors of cash, and provide Treasury collateral in exchange to secure the overnight loan. These cash investors are predominantly money market funds, most GSEs and large institutional asset managers. The cap on the overnight RRP is $300 billion. Additionally, the term reverse repo program will run four operations in December that will span year-end, with a cap of $300 billion and a maximum bid rate of 10 bp. This is the highest rate that the overnight and term program have offered for RRP cash investors. Importantly, the 10 bp rate for secured cash investments with the Fed is above current unsecured fed effective (9 bp), overnight Libor (9 bp) and AA commercial paper rates (3 to 9 bp out to 30 days).

The propagation of monetary policy. For the Fed's new monetary policy target to be effective, it will need to pressure rates higher across the short-term spectrum. The counter-parties actively participating in the Fed's RRP have been so far heavily weighted towards money market funds. The transmission mechanism for tightening credit will need to transmit from these institutional lenders of secured credit in the so-called "shadow banking system" to the secured and unsecured inter-bank and non-financial markets - tri-party repo, fed funds, commercial paper, Libor, CDs.

"I thought the Fed hated the shadow banking system." That's what's called irony. It is now dependent upon that system - and the banking system to some extent as it raises IOER - to transmit its monetary policy throughout the short-term rates complex.

Why has the Fed shifted its monetary policy target from Fed funds to IOER and reverse repo? Cursory outline in bullet points. Don't expect any nuance.

• For years, if not decades, prior to the financial crisis, "excess reserves" - or extra cash/liquidity in the banking system above the reserve requirements - used to average $20 to $40 billion per day. 
• Required reserves are roughly analogous to a minimum daily balance required for a checking account. Most depository institutions in the US have a "checking account" with a Federal Reserve bank, where they are required to maintain a minimum reserve cash balance based on things like the total amount of their daily transaction volume, size of their depository base and so on. 
• Prior to the financial crisis, if a bank exceeded the daily reserve requirement in its account, it had "excess reserves." Unfortunately, this excess cash received no interest. 
• The excess reserves can be loaned overnight from one bank to another to meet the Fed's reserve requirements. Reserve requirements are no joke: "Thou shalt not bounce a check to the Fed." Banks that had extra cash would loan it overnight to another bank to earn interest, instead of leaving it in their own account earning nothing.
• The market for these interbank loans of reserves is known as the Federal funds market, and the average interest rate at which the loans take place is known as the Fed funds effective rate. 
• The Fed used to primarily conduct monetary policy by setting a target Fed funds rate, and either increasing or decreasing the amount of reserves in the banking system to keep the Fed effective close to the target rate.
• A direct result of the Fed's quantitative easing programs is that $2.7 trillion of excess reserves / cash / samolians / clams are now floating around in the banking system. Most banks have no need to borrow reserves. 
• Furthermore, the Fed began paying interest on excess reserves (IOER) equal to the target Fed funds rate - currently 25 bp - so no bank with excess reserves has an incentive to loan them out for less than that rate. 
• The amount of lending in the Fed funds market plummeted from ~$100 to $200 billion per day (that's a best estimate) pre-crisis, to as low as $20 to $30 billion per day. Moreover, the vast majority of the lending is no longer bank to bank, but government agency (GSE) to bank, because GSEs cannot earn IOER since they are not depository institutions. 
• Instead of trying to drain the (ocean with a teaspoon) excess liquidity out of the financial system in order to raise the fed funds rate, the Fed has begun targeting other non-bank specific short-term lending rates as a target when it begins to tighten monetary policy. 
• The rates the Fed is now targeting for conduction of monetary policy are the interest on excess reserves rate (IOER) and the lending rate for the reverse repo program (RRP). 

Is this going to work? We all better hope so. Last week the Fed raised the RRP rate to 7 bp and there was a decent response from the fed effective and repo. This is a somewhat bigger test, as it should have some impact on the CP markets, even if its small. The problem with money market funds and shadow banking in general is its very bucketed in what it can and cant invest in for risk purposes. Once it fills the "repo" bucket, the funds may be forced to lend money cheaper elsewhere, simply to avoid exceeding proscribed risk limits (that were, ha ha, often the result of new Fed and SEC regulations). So the transmission may only go so far. We will get some information and report back soon.