More Clarity From The FOMC On The Mechanics Of Liftoff

by: Sober Look

The latest FOMC minutes provided some clarification on the approach the Fed is expected to take as it begins normalizing short term rates in the US. Here is a quick overview of the Fed's strategy and potential implications.

The Fed has chosen the interest rate on excess reserves (IOER) as the primary tool to control interest rates during the normalization process. While working with IOER is certainly more effective than the Fed Funds rate, there are some drawbacks. As banks pay nearly nothing on deposits and earn an increasingly higher rate on reserves, the Fed will be criticised for providing banks with more riskless profits (on some $2.5 trillion of excess reserves).

To mitigate this thorny issue, the Fed will also rely on the reverse repo program (RRP). The FOMC now views RRP as playing a "supporting role" of providing a floor on repo rates. Keeping repo rates from getting too low will allow money market funds to offer higher rates to their clients. At least in theory that is supposed to provide competition for deposits, forcing banks to raise deposit rates and limiting the deposit-to-reserves arbitrage. The FOMC wants to see the spread between IOER and RRP at around 20bp or higher.

Fed Minutes: - The appropriate size of the spread between the IOER and ON [overnight] RRP rates was discussed, with many participants judging that a relatively wide spread--perhaps near or above the current level of 20 basis points--would support trading in the federal funds market and provide adequate control over market interest rates. Several participants noted that the spread might be adjusted during the normalization process.

For example the Fed could set IOER to 50bp and RRP to 30bp. That would put money market rates at say 45-60bp and bank bank deposit rates at something like 25-35bp (currently the national average is 11bp on bank savings accounts), capping the IOER-to-deposit-rate spread.

The FOMC seems to be uneasy about a more aggressive use of the RRP, fearing that in times of crisis the participants will pile all their liquidity into the Fed facility, draining the reserves, and taking liquidity out of the private sector.

Fed Minutes: - Most participants expressed concerns that in times of financial stress, the [RRP] facility's counterparties could shift investments toward the facility and away from financial and nonfinancial corporations, possibly causing disruptions in funding that could magnify the stress.

Some are uneasy with RRP becoming a "window dressing tool", tightening liquidity at quarter- and year-end (see post). The spikes will become particularly severe during periods of financial stress, potentially causing disruptions in private funding markets.

Source: JPMorgan
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Some of the Fed officials are also afraid that the Fed could quickly become the dominant player in the repo markets, potentially resulting in some "unintended consequences". RRP will therefore continue to have limits per counterparty and is not expected to persist as a tool much beyond the period of rate normalization.

Some market participants had hoped that the RRP program will release the much needed "quality" collateral into the system, alleviating collateral shortages. The rise in treasury delivery fails continues to plague the markets (see discussion).

Source: JPMorgan
Click to enlarge

The RRP's impact on collateral shortages however is expected to be limited. Part of the issue (in addition to the RRP being more limited in scope) is that the Fed posts treasury collateral via "tri-party" repo transactions. These securities are held by a custodian bank and will generally not be "reused" as collateral elsewhere.

JPMorgan: - Higher margin requirements as a result of recent regulations on OTC derivative markets, for example, have caused a rise in collateral demand. But securities held within the tri-party system in the US are typically not allowed to be used to satisfy margin requirements. This means that the USTs released via the Fed's ON RRP facility will not have the same effect in alleviating increased collateral demand stemming from higher margin requirements, than if the Fed had directly sold these UST securities to open markets.

The shortage of collateral will continue to persist even after the end of quantitative easing, which has permanently removed too much collateral from private holders. The only solution is for the Fed to sell some of its holdings, a scenario which remains highly unlikely.

Once the FOMC is ready, the announcement of the rates "liftoff" will be accompanied by the following rate settings:

1. The Fed Funds target and the Discount window rate (traditional tool).
2. The IOER rate
3. The overnight RRP rate (20b or more below the IOER rate) and the size limit per counterparty

Other suggested tools such as term deposits (which the ECB has been using in a limited fashion for some time) are unlikely - too many moving parts for the FOMC.

Assuming things are going OK some time after the "liftoff", the Fed will announce the end of reinvestment, allowing the securities it holds to mature. This will need to happen as soon as possible in order to begin increasing the amount of collateral held by private participants.