Regional Fed bank presidents sometimes say some disconcerting things about the direction they would like to see Fed policy take. For instance, Boston Fed chief Eric Rosengren and Chicago Fed President Charles Evans have spoken out in favor of so-called 'open ended' asset purchases recently, which of course is a nice way of saying 'we support unlimited balance sheet expansion.' But perhaps more worrisome is the following statement from St. Louis Fed President James Bullard regarding the possibility of lowering the IOER rate (the rate paid to banks on reserves parked at the Fed) from its current level of .25 percent:
We've gone round and round on that issue but I think it might be time to try that out...I'd even think about going into negative territory on that...You could go to minus 25 or minus 50 [basis points and] it would definitely change the calculus for banks.
Yes it would, but more importantly, it would definitely change the calculus for money market funds. Readers may recall that when the ECB cut its deposit rate to zero in July, it resulted in JPMorgan, Goldman Sachs, and Blackrock closing euro denominated money market funds to new investors. It is important to understand why this happened, as it provides a but of insight into what would likely happen in the U.S. should the Fed decide to cut the deposit rate to zero or lower.
One way money market funds squeeze out yield on the cash they hold is by loaning money to financial institutions in repo transactions. Essentially, the money market funds loan money to banks which pledge collateral in exchange and agree to repurchase that collateral at a later date. When they repurchase it, they pay the money market fund slightly more than they borrowed and the money market fund returns the collateral -- the premium the bank paid on top of the original amount borrowed is the money market fund's to keep.
What banks have been doing -- and here is where the deposit rate comes in -- is borrowing money from money market funds in the repo market and parking it at the Fed. As long as the rate they pay back to the money market funds (i.e. the amount in excess of the original amount borrowed) is less than the .25 percent they make by parking that money at the Fed, there is an obvious arbitrage opportunity for banks.
Clearly, if the Fed cuts the deposit rate to zero or below, that arbitrage opportunity disappears and suddenly, so does banks' demand for reverse repos with money market funds. That is, no bank is going to borrow money from a money market fund and park it at 0% then pay it back to the money market fund later with interest -- that is a losing proposition. Instead, banks will simply borrow from each other and invest in short-term government paper, which, of course, would be the same short-term government paper the money market funds would be buying. All of this demand would drive down yields (demand and prices go up, yields go down) and essentially guarantee that investors in money market funds will receive nothing in terms of return on investment. There are other possible implications as well, which are discussed at length by the Financial Times.
Of course, money market fund investors are already getting next to nothing for parking their money, but a move by the Fed to cut the deposit rate would eliminate any vestige of yield from the money market landscape. While many believe the Fed won't go this route, it is worth noting that it is considered less extreme than asset purchases, and thus might be more attractive to some FOMC members. The idea behind cutting the deposit rate of course is that it will encourage banks to lend. Maybe it will, but it isn't clear if the collateral damage in terms of penalizing savers (in the person of money market investors) would be worth the effort. Indeed, the mere suggestion that the Fed would adopt this strategy suggests that if you have any money in a money market fund you would be better off just putting it in a savings account. The returns are likely to be the same, and the only counterparty risk you incur is what you take on by dealing with the FDIC.