The overnight reverse repo facility
Dr. Dudley discussed how the Fed can control the money market rates.
The traditional tool that is available with the Fed is the interest rate on excess reserves. The Fed has also been testing another tool, an overnight, fixed rate, reverse repo (or RRP) facility. Through the RRP facility, the Fed accepts cash from counter-parties such as banks, dealers, money market funds, and government sponsored enterprises and pays a fixed overnight interest rate. The facility is called a “reverse repo” facility because the counter-parties are lending to the Fed and not the other way round. If implemented, the facility could act as “full allotment” which means that there won’t be a cap on deposits accepted from any party or the Fed can decide to put a cap on aggregate or per counter-party basis.
The success of this facility largely depends on the spread between the rate offered to other risky money market instruments and the RRP rate. The narrower the spread (risky or risk free RRP), the higher the flows will be to the RRP facility. The testing process for the facility is underway. Dr. Dudley noted that the “narrower spreads to comparable money market rates and larger caps have led to greater usage,” as expected. The RRP facility is expected to set the floor for other money market rates strengthening the Fed’s control over the money market rates.
While the results of the initial testing of the RRP facility are encouraging, the following two issues related to RRP facility must be considered:
- How large should the facility be in terms of volumes?
- Will the facility make financial instability less likely?
On the first issues, Dr. Dudley said if the spread between the interest rate on excess reserves (or IOER) and the RRP rate is small, the banks will move money out of the banking system into the facility—encouraging the emergence of a shadow banking system. To avoid this, the spread between IOER and RRP should be kept wider to reduce the volumes of flows into the RRP.
The RRP facility makes a risk free short-term asset more widely available to market participants. This would discourage investment in riskier money-like liquid assets reducing the likelihood of financial crisis. However, if a financial crisis happens, there will be a rush to move money out of riskier assets into the RRP facility. Under the full allotment set-up discussed above, movement out of risky assets to the RRP could be rapid and large. As the facility is a fixed-rate facility, its demand won’t fall—unlike what happens in traditional risk free money market instruments. In traditional risk-free money market instruments, the more the money moves into the facility, the interest rates fall, and the instruments are less desirable.
To avoid the rapid and large inflow into the RRP facility during the times of crisis, the Fed can put circuit breakers, such as cap, on overall usage of the facility.
The Fed’s actions affect all the markets including bond (BND) and stock (SPY). In an improving economy, the Fed most likely increases the interest rates to control inflation. The increase in interest rates during recovery affects Treasury bonds (TLT) the most and to a lesser extent it impacts investment-grade (LQD) and high-yield (HYG) bonds. The impact of the RRP facility on the bond market is yet to be seen because the facility is still being tested.
To learn more about the term deposit facility, continue reading the next section of this series.