Bill Dudley Explains The Fed's Logic Behind The New Overnight Reverse-Repo Facility
Much attention has fallen on the Fed's recent announcement that a new fixed-rate, full-allotment overnight reverse repo facility is in the works (so much so that both shadow banking experts Singh and Stella have opined on the issue). It appears that despite the Fed's "best efforts" at communication, not enough clarity has been shed on the topic. So here is Bill Dudley's explanation.
I want to discuss a new tool that the Open Market Trading Desk (the Desk) at the New York Fed will be testing and developing in coming months. The new tool is a fixed-rate, full-allotment overnight reverse repo facility that would be available to a broad range of counterparties—not just open to the primary dealers through which we have historically conducted our open market operations.5 By being available to a much broader array of counterparties, this should allow the Fed to tighten its control over money market rates.
I’ll first explain in plain English what this facility is. Then I’ll explain why we are testing it and what having such a facility in place might accomplish.
A fixed-rate, full allotment overnight reverse repo facility is a facility in which the Federal Reserve posts a fixed interest rate and accepts cash from counterparties, which include banks, dealers, money market funds, and some government sponsored enterprises (GSEs), on an overnight basis in return for a security. If implemented, the facility would be “full allotment”—that means the facility would have no cap on the amount of funds accepted from any of its counterparties at the posted overnight interest rate.6 The repo facility is “reverse” because the direction in which the funds and securities move—participants are lending funds to the Fed rather than vice versa. Users of the facility are making the economic equivalent of an overnight collateralized loan of cash to the Federal Reserve. The amount of funds invested in the facility is likely to be sensitive to the posted interest rate. The higher the interest rate relative to comparable money market rates, the greater the participation is likely to be and vice versa.
There are several reasons motivating our interest in developing such a facility. First, such a facility should enable the Federal Reserve to improve its control over the level of money market rates. By offering a new, essentially risk-free investment, one would expect that anyone with access to such a facility would generally be unwilling to lend instead to someone else at a rate below that posted for the facility. This should help to establish a floor on the level of overnight rates. Right now, most short-term rates trade between 0 and 25 basis points, but occasionally T-bill and repo rates go negative, for example at quarter-end or when financial stresses increase the demand for very safe assets. The full allotment element of the reverse repo facility would increase the availability of a risk-free asset, satisfying the demand when the appetite for safe assets increases. This should help tighten the relationship between these and other money market rates. These reverse repos would be available to an expanded set of counterparties that includes many of the money market lenders who are ineligible to earn the interest on excess reserves (IOER), such as GSEs and a number of money market funds. Depending on the facility rate, these lenders who cannot earn the IOER rate might get a better rate by investing in the overnight RRPs compared to lending to banks or to broker dealers. This competitive effect could, in and of itself, put a stronger floor on money market rates.
Second, this new facility is also likely to reduce the volatility of short-term interest rates. If a lender that cannot earn the IOER rate has an unexpectedly large amount of funds to invest, this lender currently may have to accept an unusually low interest rate. But with the overnight reverse repo facility in place, this lender could lend as much funds as desired to the facility at a fixed rate and this should reduce the downward pressure on money market rates. By tightening control and reducing the volatility of short-term rates, such a facility should reassure investors that the Federal Reserve has sufficient tools to manage monetary policy effectively even with a very large balance sheet.
I have told you what this facility is for. Now let me emphasize what the testing and development of this facility does not foreshadow. The testing and the development of the facility is not being undertaken to facilitate or expedite exit from our large balance sheet and should not be considered to be an element of the exit process. The purpose of the facility is to establish a floor on money market rates and to improve the implementation of monetary policy even when the balance sheet is large. Even if our balance sheet increases significantly further and stays very large for many years, it will be useful to have this facility available to improve monetary policy control.
In coming months we will test the facility with two goals in mind. First, we want to be assured that there are no glitches operationally with somewhat higher transaction volumes than in previous tests, that we can accept cash from a larger array of counterparties, post collateral in the tri-party repo system and reverse the transactions each day smoothly. Second, while the limited size of the operations during this exercise will prevent the operations from having a significant impact on market rates, we will observe how the facility impacts individual investor demand relative to other market rates. Additionally, we can see how sensitive that demand is to changes in market conditions such as quarter-end that increase the demand for safe assets. These observations will give us some insight into how the facility could affect the entire constellation of money market rates. Only by testing and learning will we be able to assess how best to use the facility.
Too bad the Fed never "tested and learned" how to best use QE...
Still confused? We explained it all over a month ago in "The Logic Behind The Fed's Overnight Reverse Repo Facility: Not Taking, But Adding Liquidity" suffice to say that it is increasingly becoming clear that the Fed, as much as it is unwilling to admit it, is starting to pay attention to the collateral situation in the private markets. Or rather, lack thereof.
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