(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?
The paper
The summary:
... 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.)
Later,
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.
Last thoughts
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!
"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!"
ReplyDeleteI don't think that works, because the desired commitment (for stimulus) isn't to "low" rates, but rather "too low" rates. And 0% forever is not automatically too low - see Japan.
"However, the law allows the Fed to engage in open market transactions in U.S. government securities ... with just about anyone.'
ReplyDeleteThat is interesting. As it stands, the Fed NY will only buy and sell bonds through the 22 primary dealers, who must meet certain performance and infromation-sharing standards to maintain their status.
Indeed, this is where the $4 trillion in additional commercial bank reserves came from. The Fed digitized or printed up $4 trillion and bought $4 trillion in bonds from the 22 primary dealers (who bought the bonds on the open market), and then credited the primary dealers accounts at "depository institutions," i.e. commercial banks.
From the viewpoint of the Fed-US Treasury, this was an asset swap. Macro-economically speaking, $4 trillion in new cash entered the economy through the bond sellers.
The bond seller may have banked the money, swelling bank deposits. The record tends to not support this. There were rallies in property, stocks and growth in GDP. (Since QE, the DJIA has more than doubled, and maybe property has done almost as well).
It looks like the $4 trillion QE bond-sellers banked, invested and spent their $4 trillion.
"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." John Cochrane.
ReplyDeleteNot sure about this. The stimulus would come from bond-sellers spending or investing the Fed-freshly printed $1 trillion, which they received in return for their Treasuries.
As we know, commercial banks now have all the reserves they could want. They would have another $1 trillion in reserves if the Fed did another $1 trillion in QE. I think the reserves are unimportant at this point.
The $1 trillion in QE would be stimulative for the reasons mentioned---and why QE has been stimulative. The ultimate bond sellers (not the intermediary primary dealers) have freshly minted cash in their pockets, that they can invest, spend or bank.
Now, if the actual bond sellers bank the money, and the commercial banks sit on the deposits, that is an issue.
However, the record seems to suggest that bond sellers spent and invested a large portion of QE money (good!). Commercial bank deposits did not particularly swell during QE. Commercial bank deposits rose during QE, but they were rising before and after QE too. The FRED charts bear this out.
Commercial bank reserves, of course, exploded dollar for dollar with QE, as the 22 primary dealers get credited for their bond sales by the Fed, by an increase in their accounts at depositary institutions (commercial banks). See this from the Fed NY:
“So when the Fed sends and receives funds from the [primary] dealer's account at its clearing bank [depositary institution, or commercial bank], this action adds or drains reserves to the banking system.”
In the old days, boosting the reserves was thought to boost lending (holding reserve requirements steady). I think reserves are the opposite of rocket fuel now, they are inert.
But QE works by funneling additional fresh cash into the economy through bond sellers.
It would be interesting to start cutting IoER by a basis point a month, and see if anything happens.
Fantastic post, thanks!
ReplyDeleteBTW, the Fed having a "big" balance sheet is fine, and why it is even contemplating shrinking its balance sheet is beyond me.
ReplyDeleteThe Fed action in printing money and buying bonds was stimulative. To shrink the balance sheet, it must sell bonds, sucking money of out the economy. While we have weak growth and 1% inflation on the PCE?
I see the Fed has increased the number of intermediaries it will deal with, from beyond the 22 primary dealers--but only for its overnight reverse repurchase agreements. And yes, the Fed cannot speak clear English, and can make a simple idea complicated.
Stepping back, I do think a legitimate question is whether the Fed, dealing with primary dealers and commercial banks as clients, has not undergone regulatory capture. It would be a surprise it that were not true--most regulatory bodies seem to morph into the industries they are supposed to regulate.
The Fed has designed a stimulus scheme (QE) that benefits primary dealers (wonderful transactions business, in the trillions, literally), and results in large interest-paying reserves at commercial banks. Interest paid by the Fed, that is.
I think QE worked, just should have been bigger, harder and longer, btw.
That said, would other QE arrangements work better? What about the Fed buying bonds, and placing the bonds into the Social Security Trust Fund, concurrent to a FICA tax holiday? As a central bank, the Fed has the power to print money. So then do it. Why all this constipation about balance sheets and bank reserves?
I concur with John Cochrane that, regrettably, the Fed is facing hostile oversight from a US Congress filled with lulus and gold nuts.
Still, one has to wonder if the Fed isn't a little too cozy with financial institutions....
Thanks for the post. In not an economist. But my understanding is that if the money used in QE were to get out into circulation to quickly, the result would could be rapid inflation.
ReplyDeleteIt seem the QE goal is to restore liquidity lost, due to an accumulation of debt that could not be "serviced". With bad debt on the books, money stopped flowing. So, bad debt needed to be identified, and isolated; (taken off the books), in and effort to restore flows of money, material, and energy in was that lead to continued growth of "real wealth".
The Fed has two official goals: 1) a target inflation rate, 2) "full employment; and one unstated goal 3) restoring some financial stability resulting from the Great Recession.
There are lots of externalities affecting all three (inflation, employment and stability). But in the U.S. restoration of flows of material, energy and money is beginning to happen. Structural adjustments in exchange rates ($ vs Euros) will help in the needed rebalancing needed in relation to European exports needed to stimulate their economies.
In the U.S., new resources (natural gas, and tight oil) can be tapped; a fact that can help strengthen the value of the dollar. There are winners and loosers. We may be able to carefully grow our way back out of some of the debt, in ways that don't overshoot the Feds target inflation rates. We don't want QE $s in general circulation too quickly. Best to keep these excess reserves in a "lock box" paying very low interest. When flows of material and energy are resorted as a result of an economy that is getting back to work, one can once again increase money supplies in ways that help achieve target inflation rates. The Fed is not the one that creates money. Others issuing paper debt do as well. Key in this is issuing debt that is "good" and can be serviced, in the context of renewed, but restructured economic growth. . .
Ultimately, there will be shocks to the US and global economic system. Having an independent Federal reserve, helps absorb some of the shocks to the U.S. economy; and will help get us back on track in generation of real wealth.
I think you are mistaken about the way the ON RRP facility works. MMMF and GSEs who participate are not posting central bank reserves as collateral. They are posting cash. Investors place money in an MMMF, or the GSEs receive money from the stream of mortgage payments that homeowners make on their mortgages, and need to invest that cash somewhere. Right now, they cannot deposit it at the Fed and make 25bp. So they lend out the cash in the wholesale money markets. this is why the general collateral repo rate for Treasuries has been trading around 8bp - 16bp for the past year and why the Fed could not establish a floor under short term rates by just paying IOER. If the Fed starts raising the ON RRP rate, they can move short term rates up without changing the size of their balance sheet. that's the point.
ReplyDeleteThe concern about runs stems from the fact that MMMFs and GSEs could simply stop transacting with any private sector counterparties if there was some sort of crisis/scare and run straight to the safest counterparty in the world - the Fed - if there was no cap on the ON RRP facility. It is a legitimate concern, as tri-party repo markets would simply cease to exist, and that's not what a liquidity provider of last resort wants to see - they want to see the markets open and liquid.
But my understanding is that if the money used in QE were to get out into circulation to quickly, the result would could be rapid inflation.--Hal Walker
ReplyDeleteHal: The $4 trillion in QE is in circulation, and has been!
When the Fed conducts QE, it buys bonds from the 22 recognized primary dealers. It bought $4 trillion in bonds from those 22 dealers, and credited their accounts at depositary institutions (commercial banks) to the tune of $4 trillion. That was the $4 trillion in new excess reserves.
But the story does not stop there. The bond dealers paid cash (that was printed up by the Fed, so to speak) for the $4 trillion in bonds, making purchases on the open market. in this regard, it was just a giant Fed open market operation, but all buying, bigger than ever before.
The market sellers of the bonds then have $4 trillion in fresh money in their hands. They can invest the $4 trillion, or spend it, or bank it.
Initially, the bond sellers do make deposits in bank accounts, when they are paid for their bonds--but oddly, no one seems to know what the bond sellers did next with their $4 trillion. No surveys have been done, to my knowledge (and I scoured the I-net). No one at the Fed seems especially curious. Our macroeconomists are not bankers, and thus are also not that curious. Some of our macroeconomists even erroneously say "QE was just a swap of bank reserves for Treasuries" --having seen the one-for-one expansion of bank reserves when Treasuries were sold.
The NYFed website explains this nicely, in their sections on primary dealers and open market operations. The Fed even had to set up a special credit facility during QE to give the 22 primary dealers money so they could buy enough bonds in the open market.
"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."
ReplyDeleteBut, back in September, you were arguing that if the Fed starting paying interest on reserves (thereby raising rates) this would not materially affect its remittances to the Treasury or the deficit (see comments, here):
http://johnhcochrane.blogspot.fr/2014/09/fomc-statement-and-new-normal.html?showComment=1411052416780
What gives?
Viv
I was simplifying, as often happens on a blog. If the Fed held entirely short-term treasuries, in fact, then it could quickly pay more interest on reserves from the higher interest on Treasuries. But the Fed holds long term bonds. So when interest rates go up, the value of its bonds goes down and it suffers a big mark to market loss. Now, the Fed doesn't plan to sell those bonds (the mark to market loss is a big reason why!) and they're paying something like 2% coupons, so on a cash basis the Fed can happily continue to pay up to 2% on reserves and wait for the bonds to run off. But then it won't be rebating that 2% to the Treasury.
DeleteThe rebate to the treasury business, as well as the Fed's mark to market losses are all a tempest in a teapot. The Fed's mark to market loss is the Treasury's mark to market gain. The Fed is rebating to the Treasury money that the Treasury pays to the Fed in interest. The Fed is not some magic pot that can fund government spending!
It is mostly important in the politics and optics of the business, but not to the economy or to the consolidated government budget constraint .
The Fed is not some magic pot that can fund government spending! --John Cochrane.
DeleteAre you being facetitious, and I lack the IQ to see that?
Or, is this a moral, political, or practical statement? Under GAAP?
It sure looks to me like the Fed indeed has funded government spending under QE, and it stimulated the economy, but, curiously, resulted in little inflation. Maybe it only delayed deflation.
QE was just a giant one-way open market operation (OMO), conducted through the 22 primary dealers with whom the Fed has long dealt. The Fed bought $4 trillion in bonds, and credited the primary dealers' accounts at commercial banks to the tune of $4 trillion. That is where the huge increase in bank reserves came from.
In the old days, the increase in bank reserves would have allowed more bank lending, thus commercial bank stimulus. Not now. There are excess reserves. Adding reserves now is just piling on.
However! and it is a gigantic however, even in the old days, when the Fed did OMO and bought bonds there was also another kind of stimulus, as bond sellers went from having an inert instrument---a Treasury bond---to having cash. They could spend the cash, or invest in other assets, or bank it.
One of the current curiosities of the Fed and modern macroeconomists is how incurious they are as to what the sellers of bonds to the Treasury are doing with their $4 trillion in fresh QE cash.
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. click this link
ReplyDelete"I was simplifying, as often happens on a blog... they're paying something like 2% coupons, so on a cash basis the Fed can happily continue to pay up to 2% on reserves and wait for the bonds to run off. But then it won't be rebating that 2% to the Treasury."
ReplyDeleteWell, that was exactly my point in the original comment, to which you then simply, but clearly replied "not correct". Sorry, John, but in that exchange you gave a very specific example IOR rising to 5 percent, not 2) and still insisted this would not eliminate Fed transfers to the Treasury or influence the deficit. Now, you seem to be saying that those transfers will be *eliminated* if IOR rises to 2 percent and thus the deficit will be increased by about $100 billion! I can't attribute that to simplification.
And, how does this go from your colleague's "brilliant observation" to this now being a "tempest in a teapot"? It appears to me that, for budget purposes, those Fed transfers to the Treasury will disappear and this has budgetary consequences to the tune of about $100 billion per annum. And, while you may be again simplifying on a blog, as long as I've been around it is simply not true that the Treasury marks its outstanding notes and bonds to market. The Fed of course, does, with respect to its balance sheet.
It strikes me that the effect of these temporary Fed transfers has not just been on the budget---it has arguably been the equivalent of up to a $100 billion quasi-helicopter drop per year---without those transfers federal spending quite likely would have been lower.
Viv
Moving money from the right pocket to the left pocket is a tempest in a teapot for the household budget constraint, but a big deal for the right pocket.
DeleteRight, but who has ever been talking about "a household budget"? The discussion is, and always has been, about the *federal budget*. Sorry to say, but you are simply not being substantively responsive here, John. When I made the observation earlier about the effect on the federal budget, it was "not correct". When your colleague made that same observation, it was "brilliant".
DeleteViv
The Fed can tighten, albeit slowly, by the simple expedient of not re-investing payments received on all the MBS, and other term debt, they bought.
ReplyDeleteThe assertion that increasing rates will increase growth and inflation seem to be decisively rebutted by your chart with the red, blue and green lines showing increasing rates leading to the opposite result. The same chart shows that the history of the Fed in the last 20 years has been to raise rates too high (2000-2003 and 2006-2009) in response to some perceived problem.
The key line in the FOMC minutes is that market participants are only OK with the caps as long as they are not binding, i.e. the caps will be continually raised, as they have been all along. You can keep track of the treasuries on loan by the Federal Reserve through the RRP facility and see that the repo market has become increasingly dependent on the facility and usage has continued to increase exponentially.
ReplyDeleteIndeed, at some point in the future the repo market will demand every US Treasury security on the Fed's balance sheet. A lack of further collateral issuance would invariably cause a systemic catastrophe throughout the repo market. The only response the Fed would have to such a scenario would be to conduct further unnecessary quantitative easing (in order to add US Treasury securities to its balance sheet, that it could then use in the RRP facility). Indeed, that is exactly what will happen. Only the repo market will continue to demand even more collateral, and the Fed will have to conduct more and more quantitative easing to feed the beast.
John, I'd still be interested to hear you address the implications of the ON RRP facility reaching the limits of the Fed's balance sheet. The Fed has continually raised the ON RRP caps (both per institution and overall) since the facility began day-to-day "tests" (i.e. operations) in 2013. For example, here are the quarter-end allotments to date:
ReplyDelete3Q 2013: $58 billion
4Q 2014: $198 billion
1Q 2015: $242 billion
2Q 2015: $339 billion
3Q 2015: $407 billion
4Q 2015: $474 billion
As you can see, the repo market has become increasingly dependent on ON RRP funding. When the Federal Reserve hinted in the September 2014 FOMC minutes at a firmer stance regarding the caps, market volatility immediately increased, and was only assuaged when the Fed backtracked at it's next meeting. Since then, the Fed has hinted at soft caps only ... i.e. caps that will be raised over and over again. Indeed, I pointed out in my previous post the key line in the latest FOMC minutes:
" the staff reported that testing to date suggested that ON RRP operations have generally been successful in establishing a floor on the level of the federal funds effective rate and other short-term interest rates, as long as market participants judge that the aggregate cap is quite unlikely to bind."
It is easy to extrapolate the current trend and foresee a date in the not-too-distant future where $58 billion ... $198 billion .. $474 billion ... eventually equals the amount of all US Treasury securities on the Fed's balance sheet. What then? Will the repo market suddenly cease to demand more collateral? Of course not!
What the Fed is doing through it's ON RRP program is attempting to eliminate risk in the repo market, but since risk cannot be eliminated, it is unintentionally eliminating independent repo markets altogether! The market is in the process of shifting all intermediation to the Fed. The last available data I have for the size of all repo markets is ~$6 trillion, and the Fed's ON RRP program is begging to transfer all $6 trillion onto its balance sheet. The Fed of course does not have $6 trillion in US Treasury securities on its balance sheet however, and so the ON RRP facility -- on its current pace -- will necessitate the Fed acquire another $4 trillion in US Treasury securities. And then the repo market will need to grow further, demanding even more Treasury securities be added to the Fed's balance sheet at an even more exponential pace.
These are the systemic risks I think are inherent in the RRP facility, and I would love to hear your thoughts.