(I should have found it on my own, as it's the top paper on the Fed's working paper list.) Cecchetti and Shoenholtz also comment here
My main question was just what "financial stability" concerns the Fed has with RRP, and this paper explains.
Background and recap
A quick recap and background, informed by comments and some helpful emails (thanks): Banks have about $3 Trillion reserves, corresponding to $3 Trillion of securities that the Fed bought. When it's time to raise rates, the Fed plans to just pay higher interest on these reserves. The Fed is worried banks will just say "thank you" and not raise deposit rates. So the Fed is effectively offering money market funds (etc) the opportunity also to invest in interest-paying reserves. If banks don't raise deposit rates, funds will, and try to attract bank deposits. The funds will also try to sell Treasuries, raising those rates.
In a reverse repo, the lender gives the Fed cash (reserves), and the Fed gives the lender securities as collateral. Why reverse repos? A correspondent explains, "The Federal Reserve Act allows the Fed to take deposits only from depository institutions and the U.S. government (including GSEs) and to pay interest only to depository institutions. It would take an act of Congress to allow the Fed to pay interest on accounts held by MMMFs. However, the law allows the Fed to engage in open market transactions in U.S. government securities ... with just about anyone."
Key points: The Fed is still controlling the size of the balance sheet. If the Fed really wanted an ironclad (rocket-powered?) liftoff tool, it would say "Bring us your Treasuries. We will give you interest-paying reserves in return." Then, if bond markets give the Fed $1 trillion of treasuries, the Fed creates an extra $1 trillion of reserves. (Yes, increasing the balance sheet is a tightening move. Welcome to our new world.) If you want to peg a price (interest rate), announcing "do what it takes" quantities is a good idea. The Fed is not planning to do this. (Yet!)
The Fed is also contemplating caps on the size of the facility, rather than "full allotment." Full allotment is obviously more powerful. One wonders what happens if the Fed says 1%, Deposit rates go up 0.2%, treasury rates go up 0.2%, and the Fed hits the cap.
Important point: every dollar of new reverse-repo "deposits" at the Fed must come from one dollar less bank reserves at the Fed. The money market fund desiring to do an RRP must sell treasuries (or something else), get some reserves, give those reserves to the Fed. The only place those reserves can come from is a bank. So, on net, bank reserves go down $1, and money fund holdings of reserves go up by $1. It's a shift from left pocket to right pocket.
Moreover, the Fed is offering nothing that a money market fund backed by short-term Treasuries and agency securities can offer. The Fed is nothing but a money market fund backed by Treasury and agency securities!
With this background, I find it hard to understand how the ON RRP can have any "financial stability" problems. How can opening up a money market fund invested in Treasuries and Agency securities be dangerous?
... an ON RRP facility could have repercussions for financial stability. These might include beneficial effects arising from the increased availability of safe, short-term assets to investors with cash management needs.Yes! Translation 1) Interest-paying narrow banking is great for stability.
However, there may be adverse effects stemming from the possibility that such a facility—particularly if it offers full allotment—could allow a very large, unexpected increase in ON RRP take-up that might enable disruptive flight-to-quality flows during periods of financial stress. In addition, very large usage of an ON RRP facility, particularly if it were permanently in place, would expand the Federal Reserve’s footprint in short-term funding markets and could alter the structure and functioning of those markets in ways that may be difficult to anticipate. Indeed, FOMC policymakers have expressed concerns about a sustained expansion of the Federal Reserve’s role in financial intermediation and the risk that ON RRPs might magnify strains in short-term funding markets during periods of financial stress (FOMC 2014a,b).2) But maybe it would facilitate a flight to quality or run. 3) Banks won't like it if we take over their business. 4) Our bosses have already opined on this question, so don't expect us to take a strong stand.
The paper starts with point 3)
3.1. Potential effects of a very large ON RRP facility on financial intermediation
By offering a new form of overnight risk-free investment, an ON RRP facility could attract cash from investors who otherwise might provide funding for private institutions and firms. That is, the facility could expand the Federal Reserve’s role in financial markets by offering investors a new tool to manage liquidity and thus could crowd out some private financing...I think this is just wrong, and it reflects a classic confusion of the individual and the aggregate. As above, the Fed holds the same number of treasuries. For every dollar of reserves held by money market funds under RRP, banks must hold one dollar less.
Importantly, increased ON RRP take-up does not expand the size of the Federal Reserve’s balance sheet or the volume of private short-term funding required to finance that balance sheet. Instead, such an increase shifts the composition of the Federal Reserve’s liabilities from reserves held by banks to RRPs that can be held by a wider range of institutions. ...This paragraph, following the last, seems to validate exactly my point.
..., a permanently expanded role for the Federal Reserve in short term funding markets could reshape the financial industry in ways that may be difficult to anticipate and that may prove to be undesirable. For example, a permanent or long-lasting facility that causes very significant crowding out of short-term financing could lead to atrophying of the private infrastructure that supports these markets. Partially in response to some of these concerns, the FOMC has made clear that an ON RRP facility is not intended to be permanent (FOMC 2014c).These markets failed! The run on repo was central to the financial crisis! This is like the 19th century US deciding that we shouldn't issue Federal currency, as it will displace private banknotes. The Fed seems to see no problem in displacing or regulating out of existence many other contracts and practices. From a bit later
a recent literature has emphasized the benefits of the public provision of safe short-term assets, such as ON RRPs, in enhancing financial stability by displacing private money-like assets that are prone to runs.Yes!
Now, the central point 2) financial stability in a run.
3.2. Potential effects of an ON RRP facility on financial stability
In principle, there are two distinct channels through which the establishment of an ON RRP facility could affect financial stability. First, the availability of an elastically supplied risk-free asset could influence the likelihood that money market investors would shift rapidly from providing private short-term funding to holding only very safe assets. That is, the facility could affect the chance of a widespread run. Second, an ON RRP facility could affect the dynamics and severity of such a shift, once it is under way.... The academic literature does not provide strong guidance regarding the effects of a new risk-free asset on the likelihood of sudden shifts toward safe assets.Again, I think this is wrong, and confuses the individual with the aggregate. Sorry to be blunt. Investors wanting to run can, and did, hold bank accounts, cash, money market funds invested in Treasuries, or short-term treasuries. The aggregate amounts of these are not changing.
It is also quite a curious attitude that the Fed should limit the provision of money-like assets in a run, and insist that prices plummet instead. By and large the Fed does exactly the opposite. The Fed flooded the market with money in the crisis, as it is supposed to do and will do again. (As the paper explains nicely).
If the Fed does not buy assets, the private sector cannot in total sell them.
Mistaking individual flows for aggregate flows is one of the most basic (and easy) errors in thinking about financial markets. Daily, news outlets tell us that "investors fled from stocks to bonds" or vice versa. No they didn't. For every seller there is a buyer.
... once a run is underway, the availability of ON RRPs could allow greater flight-to-quality flows during a run and thus could exacerbate the run and its effects. These effects might be particularly significant with a full-allotment ON RRP facility, but they also could occur with facility that does not offer full allotment if its structure leaves the potential for a sudden and unexpected large increase in take-up.But for every dollar of MMF take up, there must be a dollar less of bank take up. The paper says the same thing several times.
3.2.2. Effect on the dynamics and severity of a run (once it is underway)
Absent an ON RRP facility, in the event of a widespread run from private short-term funding markets, the supply of safe assets, such as Treasury securities, would not expand automatically to accommodate increased demand. Hence, without ON RRPs, opportunities to run may be constrained by a limited supply of risk-free assets, and greater demand for those assets is likely to push up their prices and make running more costly.
By contrast, an ON RRP facility that elastically supplies a very safe asset and which has the potential to increase in size by very large amounts would provide no immediate mechanism to slow a run. Hence, some market observers have suggested that such a facility could exacerbate flight-to-quality flows and their repercussions (Wrightson ICAP 2014).But the RRP facility does not "elastically supply a safe asset," on net. The size of the balance sheet, and the total amount of reserves, remains fixed. (Except that the Fed will be dramatically expanding the balance sheet in any run anyway, buying up all sorts of dodgy debt, not forcing people to sit on such debt as this argument envisions.)
There is a bit of sense in this:
... Cash that, in the absence of ON RRPs, might have moved quickly to liquid deposits at banks could go instead into a risk-free ON RRP facility through, for example, government MMFs that invest in ON RRPs. The sources of flight-to-quality flows, such as prime MMFs, could experience larger outflows than in past episodes, and the availability of short-term funding for broker-dealer and nonfinancial firms through vehicles like repo and CP could decline more quickly.It starts by repeating my puzzle. People who want to run, can run to bank accounts. So RRP makes no difference. But (not said), large investors can't get insured deposits. So maybe maybe, an investor holding a prime fund (invested in Lehman debt) would be more likely to run if funds that invested in RRP were available?
But... money market funds that invest in short term treasuries remain available. Treasuries themselves are available (we're talking large institutional investors here not mom and pop.)
all else equal, increased ON RRP usage implies reduced short-term financing for other borrowers. If, for example, MMFs quickly shift from investing in commercial paper or repo to holding ON RRPs, they would reduce the availability of short-term credit for private firms and institutions. More generally, in contrast to classic central bank liquidity provision, which creates reserves, increased ON RRP take-up diminishes reserves.
I still think this confuses individual portfolio shift for aggregates. For a fund to increase ON RRP, it has to get reserves from somewhere. If it sells an asset to another investor in exchange for the reserves, now that other investor holds the asset.
We're going around in circles, so I'll stop here.
I heard one very good argument at lunch today: If there is a large RRP facility, and if many large money market funds are half invested in, say, Greek bank debt and half invested in RRP, then the Fed may feel that these funds are "too big to fail" because they're holding so much reserves, and feel the need to bail them out of their Greek debts. That, however, is a cynical colleague at lunch and not in this paper.
In response to these concerns, the Fed is planning to hobble the effort:
... the FOMC has already indicated in its Policy Normalization Principles and Plans that the facility will be phased out when it is no longer needed to help control the FFR, and its temporary nature should mitigate some concerns about impacts on short-term funding markets (FOMC 2014c). In addition, caps on ON RRP usage could be imposed to limit the Federal Reserve’s footprint in short-term funding markets or to contain potentially destabilizing inflows into the facility during periods of financial stress.
On a long plane flight yesterday I watched Janet Yellen's testimony in the Senate Banking Committee. I was impressed by her masterful handling of the questions. And I gained a new appreciation of the political constraints the Fed is operating under here. Paying large interest on reserves and opening that up to Wall Street is going to be tough, no matter how great as a matter of economics. I understand the strong desire to label monetary policy "normal."
Here I think the Fed dug itself in a bit of a hole. By trumpeting how great QE was, and how much stimulation it did, the Fed now would find it very hard to say "we've been reading Cochrane (and many others) and the huge balance sheet is doing nothing at all stimulative and is kinda nice for financial stability. So we'll just leave it all outstanding and pay IOR, and call that 'normal'."
Another colleague's brilliant lunch insight. The Fed may have deliberately dug itself in a hole. By buying lots of long-term bonds, the Fed will take big mark to market losses if interest rates rise, and stop remitting money to the Treasury. This is a precommitment not to raise rates. So, a good answer to "how did QE 'work'" is not just by implicitly promising to keep rates low for a long time, but by making it very hard to raise rates!