The most recent FOMC Minutes came out a few weeks ago. There were no surprises in terms of data, but we finally know how the Fed plans on using the interest rate on excess reserves (IOER), in conjunction with overnight repurchase agreements (O/N Repos), to direct the fed funds rate. For years we've known the Fed would use the interest rate on excess reserves as a tool to increase the fed funds rate, but today the minutes provide a clear understanding of the strategy behind that plan. The other revelation gained as a result of reading through the minutes, perhaps more of a confirmation, is that Janet Yellen has a more progressive/aggressive stance on the timing of the "liftoff" date than several of her colleagues at the FOMC.
Fed Funds Rate Hike: The Mechanics
Ben Bernake first announced that the IOER would be used as the tool to increase the fed funds rates in late 2013. The use of the IOER was formalized in late 2014 as part of a general exit plan, but it was not specific. Last week we were given those specifics.
These are the objectives as laid out in the FOMC minutes from the February meeting:
- Continue to target a range for the federal funds rate that is 25 basis points wide.
- Set the IOER rate equal to the top of the target range for the federal funds rate and set the offering rate associated with an ON RRP facility equal to the bottom of the target range for the federal funds rate.
- Allow aggregate capacity of the ON RRP facility to be temporarily elevated to support policy implementation; adjust the IOER rate and the parameters of the ON RRP facility, and use other tools such as term operations, as necessary for appropriate monetary control, based on policymakers' assessments of the efficacy and costs of their tools. The Committee expects that it will be appropriate to reduce the capacity of the facility fairly soon after it commences policy firming.
The first objective is a continuation of the last 7 years -- a target range is easier to achieve than a specific rate. It goes on to say that the IOER should be set to the top of the range as the ON RRP (overnight repurchase agreement) sets the floor.
What exactly does this mean? If the new target range is .25% to .50%, the IOER will be set at .50%. The IOER acts like an upward magnate by pulling the fed funds rate up to a ceiling. It looks a little something like this:
Source: Author's calculation
Theoretically, if we were to graph this chart it would look something like this, with the fed funds rate falling right in the middle.
How Does It Work
Before the O/N reverse repo, the Fed didn't have the ability to make the IOER available to anyone -- the Fed controls the IOER, not who's eligible to receive it -- but it can make the ON RRP available to anyone. In effect, they're both the same. The IOER is the rate the Fed pays banks; the O/N reverse repo is the rate the Fed pays everyone else, including money market funds, non-banks, and government sponsored entities (GSEs). Naturally, the ON RRP is going to be a popular product, who wouldn't want to lend money to the Fed -- is there a more credit worthy borrower than the Federal Reserve?
From a monetary policy perspective, the IOER increases the fed funds rate by placing more demand on short-term money. The reverse repo (another way of referring to a short-term loan that earns interest from the Fed) is offered to a larger group of both banks and non-banks. To be clear, these organizations can now lend cash to the Fed on an overnight basis. For a list of the organizations currently eligible to participate in the ON RRP offering click here; note the GSEs and money market funds.
In order to participate in the ON RRP organizations must have a minimum of $10 billion in reserves which effectively raises the reserve requirement. It also stipulates that government sponsored entities must "maintain a minimum of $1 billion in average daily outstanding amount of RRP transactions; and money funds must maintain a minimum of $5 billion in net assets at each month-end". The Fed is expanding the reserve mechanism for anyone that wants to lend money to the Fed.
The last point refers to the use of the ON RRP facility at elevated levels; what is the significance of this? The FOMC has been testing both overnight and term reverse repos for the past year. As you can see from the chart below, there's been a large increase in volatility over the last four months. I suspect much of the volatility in reserves is due to reverse repo exercises.
The Fed is stopping short of full-allotment (allowing the unlimited borrowing of funds) but is putting a very high cap on the amount of the offering while the IOER is being raised. The Fed has said that the cap on the reverse repo facility will only be raised for a short period of time, but we don't really know what that is. Even if it is elevated, the Fed can certainly increase the frequency of offerings. Personally, I think the O/N reverse repo is here to stay.
Conclusion: History In The Making
What will the effect of the ON RRP be on the market? QE gave banks reserves. Banks are effectively lending the Fed those reserves and the Fed is paying banks .25% as a rate of interest on those reserves. The ON RRP casts the net even wider including those organizations that aren't eligible for the IOER. In so doing, the Fed created an arbitrage market among banks and other financial organizations. In a nutshell, these two tools allow the Fed to drain the economy of money by bringing it all into reserves. The more the Fed pays banks with interest, the less money will be lent out to businesses and consumers. This is perhaps the only way the QE unwind was going to work without the creation of inflation, and it will go down in history as being ingenious -- if it works.
Is Bank Profitability Linked To Excess Reserves?
Does The Federal Reserve Care About Economic Growth?
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