As recently as a month ago we were pounding the table that the Fed's reverse-repo program, which was long said to be, alongside the IOER, the key component that would enable the Fed to hike rates in an environment in which the Fed Funds rate is no longer relevant, is a joke, most notably in "Why The Fed Is Full Of It: Reverse Repo Is A Fairy Tale."
What we also repeated is that while the RRP is meaningless for actual monetary policy it is quite meaningful as a Fed-funded and subsidized quarter-end window dressing facility, widely used by money market funds and banks at the end of every quarter to make their balance sheets appear of higher quality than they are.
Which brings us to yesterday's FOMC minutes. It was there that the FOMC once again reminded everyone of the trivial folly which is speculation just when the Fed will hike rates, when the Fed itself still has no idea how it will actually implement this mechanically, theoretically or practically.
From the FOMC Minutes:
... the manager reported on potential arrangements that would allow depository institutions to pledge funds held in a segregated account at the Federal Reserve as collateral in borrowing transactions with private creditors and would provide an additional supplementary tool during policy normalization; the manager noted possible next steps that the staff could potentially undertake to investigate the issues related to such arrangements.
So what are segregated cash accounts? Goldman explains:
The October FOMC minutes revealed a discussion of "potential arrangements that would allow depository institutions to pledge funds held in a segregated reserve account at the Federal Reserve as collateral in borrowing transactions with private creditors and would provide an additional supplementary tool during policy normalization." This idea has been discussed in the past by Fed officials, but has not figured prominently into exit discussions to date.
To understand the importance of this proposal, note that a traditional bank deposit has only a general claim on the assets of the bank, which includes both risk-free assets (such as reserve balances and T-bills) and risky assets (loans, securities, etc.) The proposal would create a special class of account that has a "perfected collateral interest" in specific risk-free reserve assets held by the bank at the Fed. Essentially, it would make the investment risk free from the perspective of the depositor. This is the case regardless of whether the deposit would not otherwise qualify for FDIC insurance. Implementation of these kinds of accounts would presumably reduce the shortage of short-term liquid assets discussed, for instance, at the most recent Treasury Borrowing Advisory Committee (TBAC) meeting.
The bank would earn interest paid on excess reserves (IOER) on the balances, while the rate earned by the depositor would be market-determined. As a result, the extent to which this proposal could smooth the implementation of monetary policy depends heavily on whether such accounts would qualify for a regulatory exemption of some kind, for instance, if banks could treat reserve balances collateralizing the accounts as custodial (and hence off balance sheet) assets. This would reduce the intermediation spread charged by banks—the reason why the effective fed funds rate is much lower than IOER currently—and allow money market rates to be pulled up closer to IOER.
Even without any special favorable capital treatment, segregated reserve accounts could enhance the transmission of monetary policy due to market microstructure considerations. Increasing the number of counterparties with whom cash-rich participants would potentially be willing to invest would increase the bargaining power of lenders vs. borrowers in the money market, perhaps resulting in slightly firmer short-term interest rates.
In addition, we expect that some important lenders in fed funds would prefer segregated reserve accounts to participation in the RRP facility, as it would likely afford more flexibility in when cash could be returned vs. tri-party repo.
Quick note: where Goldman says "segregated reserve accounts could enhance the transmission of monetary policy due to market microstructure considerations" what they mean is simple: there is an unprecedented "money-good, reserve-equivalent" collateral shortage across all asset classes, which in turn is putting various collateral-extracting counterparties under the microscope by other counterparties, if not the Fed. The paradox, clearly, then is that through its 6 years of easing, the Fed has made the very process of tightening impossible, and is now scrambling to find new and improved ways for the banks to agree to stick their hands in the sand and pretend like there is no high quality collateral shortage.
This approach failed to gain traction with the Reverse Repo facility, so the Fed is now hoping it may work with "segreggated reserve accounts."
So, sure enough, one after another banker, the same who lauded the RRP program when it was first introduced a year ago, are rushing to praise the segregated accounts idea. Some soundbites from Bloomberg:
- Potential segregated accounts proposal mentioned in Oct. 28-29 FOMC minutes could be an alternative to the Fed’s O/N RRP facility, Credit Agricole strategist David Keeble said in phone interview.
- Fed officials don’t like the reverse repo facility; “they see it as poison”; Segregated accounts ARE “just another way to suck out cash” Keeble said adding banks won’t incur FDIC deposit fees so the accounts "circumvent problems domestic banks have” and put all institutions “on a level playing field”
- Fed has capped O/N RRP at $300b “so they need to look at other ways to put a harder floor under rates. It’s prudent planning on their part,” Citi strategist Andrew Hollenhorst said in phone interview
- If the Fed goes “down this route with segregated accounts, all money market rates will rise.”
- Segregated cash account (SCA) proposal hearkens to New York Fed/ECB workshop on excess liquidity and money market function in Nov. 2012
- SCAs could “perfect a collateral interest in specific assets (reserves)” on bank’s balance sheet
- Would be created at bank by three-party agreement with lender, bank and Fed: Funds could be wired into account, which directs reserve balances
- Only lender-depositor could issue instructions to make payments out of account, can’t be moved by bank
And so on, but the gist is clear: over a year into the lifetime of one of the two key rate hiking pillars, the RRP, the Fed has given up on its as a primary component of the tightening cycle, and now, a few months ahead of when many believe the Fed will proceed to hike rates, the Fed is proposing a brand new and completely untested mechanism with which to extract record cash from the system.
Bottom line: it has become quite clear that the Fed neither has the intention, nor the market mechanism to do any of that, and certainly not in a 3-6 month timeframe. Which may explain the Fed's hawkish words on any potential surge in market vol. After all, if the nearly $3 trillion in excess reserves remain on bank balance sheets for another year, then the only reason why vol could surge is if the Fed lose the faith of the markets terminally. At that point the last worry anyone will have is whether and how the Fed will tighten monetary policy.