Everything that needs to be said has already been said.
But since no one was listening, everything must be said again.

Andre Gide

Wednesday, November 25, 2015

Lift off in a world of excess reserves

Back in the good ol' days, U.S. depository institutions (mostly banks) held just enough cash reserves (deposits they held at the Fed) to meet their settlement needs. At the end of the day, a bank short of reserves could borrow them from a bank with excess reserves. These trades would occur on the so-called federal funds market and the interest rate agreed upon on these (unsecured) overnight loans is called the federal funds rate (FFR). In fact, there was (and is) no such thing as "the" FFR because these trades did not (and do not) occur in a centralized market at a single price. Trades in the FF market occur in decentralized over-the-counter markets, with the terms of trade (interest rates) varying widely across transactions (see figure 12 here). "The" FFR we see reported is sometimes called the effective FFR. The effective FFR is just a weighted average of reported interest rates negotiated in the federal funds market.

For better or worse, the FFR was (and still remains) the Fed's target interest rate. Prior to 2008, the Fed (actually, the FOMC) would choose a FFR target rate and then instruct the open markets trading desk at the New York Fed to engage in open market operations (purchases and sales of short-term Treasury debt) to hit the target. To raise the FFR, the trading desk would sell bonds, to lower it, they would buy bonds. (Evidently, even the mere "threat" of buying and selling bonds following an FOMC policy rate announcement often seemed sufficient to move the market FFR close to target.) The way this worked was as follows. A sale of bonds would drain reserves from the banking system, compelling banks short of cash in the FFR market to bid up the FFR rate. A purchase of bonds would induce the opposite effect. The system worked because banks were compelled to economize as much as they prudently could on their reserve balances. Prior to 2008, the Fed was legally prohibited from paying interest on reserves (IOR).

But the world is now changed. In 2008, the Fed started paying a positive IOR (25 basis points). And it started buying large quantities of U.S. treasury and agency debt. The Fed funded these purchases with interest-bearing reserves. It may seem like a strange thing to do, but from a banker's perspective it looks brilliant. Imagine buying a risk-free asset yielding 2-3% and funding the purchase by borrowing at 1/4%. The profit the Fed makes on this spread is mostly remitted to the U.S. treasury (i.e., the taxpayer). In 2014, the Fed remitted close to $100B.

The U.S. banking system is now flush with reserves--most depository institutions (DIs) hold "excess" reserves. (Incidentally, there is no way for the banking system collectively to "get rid" of these excess reserves. In particular, the banking system as a whole cannot "lend out reserves.") And since most DIs have excess reserves, the FFR market is essentially dead.

Well, not quite dead. There are still a few trades, motivated  primarily by the fact that some key participants in the FF market (GSEs) are legally prohibited from earning IOR. The Federal Home Loan Banks, in particular, have a large supply of funds that, if they could, would happily hold these deposits at the Fed earning 25bp. Instead, they must hold these funds with DIs, who are able to earn IOR (see here). Because short-term treasury debt is yielding close to zero, the effective FFR negotiated between DIs and non-DIs lies somewhere between zero and IOR (see following graph). According to Afonso and Lagos (2014),  the volume of trade in the FF market has dropped to about $40B per day from its peak of $150B per day prior to 2008 (see their figure 4).

Alright, so where are we at? Since 2008, the Fed has congressional authority to pay IOR (to DIs only). The Fed can clearly set IOR where ever it wants (within limits). So when lift off date arrives, raising IOR by (say) 25bp will pose no problem from an operational viewpoint.

The Fed, however, has elected to keep the FFR--not the IOR--as "the" policy rate. Given this choice, there is the question of how the Fed expects to influence the FFR when there is no (or very little) FF market left in this world of excess reserves. Theoretically, IOR should serve as a floor for the FFR. But evidently there are "balance sheet costs" and other frictions that prevent arbitrage from working its magic. So the problem (for the Fed) is how to guarantee that its policy rate--the FFR--will lift off along with an increase in IOR.

Enter the Fed's new policy tool -- the overnight reverse repo (ON RRP) facility, overseen by Simon Potter of the NY Fed. Actually, the tool is not exactly new. The Fed has historically used repos and reverse repos for a long time; see the following graph.

In a repo exchange, the Fed buys (borrows) a security from a DI in exchange for reserves. In this case, the DI is borrowing reserves from the Fed. The value of the Fed's repo holdings is plotted in red above. Since the advent of QE, the repo facility has remained dormant. In a reverse repo, the Fed sells (lends) a security to a DI in exchange for reserves. In this case, the DI is lending reserves to the Fed--that is, reverse repo is just a way for the Fed to pay interest on reserves. The blue line above plots the value of reverse repo holdings.

What's new about the ON RRP facility is that it is open to an expanded set of counterparties (beyond the regular set of DIs). The NY Fed publishes a list of these counterparties here. It is notable that GSEs and MMMFs are including in this list.

Lift-off (an announced increase in the FFR target rate or band) will then be accompanied by an increase in the IOR to (say) 50bp together with an ON RRP rate of (say) 25bp. The hope is for the effective FFR to trade somewhere within this interest rate band. Theoretically, the ON RRP rate should provide an effective floor for the FFR--assuming that the facility is conducted on a full allotment basis (i.e., assuming that the facility is not capped in some manner). If the facility is capped, and if the cap binds, then we may observe trades in the FF market occurring at rates lower than the ON RRP rate. This latter scenario is obviously one that the Fed would like to avoid.

There is also the question of whether other market interest rates will follow the FFR upward in the present environment. Some economists, like Manmohan Singh of the IMF worry that the Fed is using the wrong tool for lift off (see his piece in the Financial Times here). Singh would prefer outright asset sales because the treasuries released in the market can then be left to circulate (via re-use and rehypothecation) to relieve an ongoing asset shortage. (The securities released by the Fed in its ON RRP facility are evidently not expected to circulate.) It is conceivable, though perhaps unlikely, that the yield on short-term treasuries remains close to zero (reflecting a stubborn liquidity premium) even as the FFR is increased. As always, it will be interesting to see what actually transpires.


  1. Finally someone has explained in simple words what the real risk of qe is. It is that the Fed has lost the monetary control necessary to force interest rates up. The Fed used to control the marginal dollar in overnight balances. Now it can only raise rates by paying more for its funds than the rest of the interbank market. It is strange when the ultimate risk free rate, the rate paid on reserves at the Fed, is higher than the interbank market but that's what we have.

  2. If the IOR and ON RRP are the only two tools that are used, what was once a profitable program will switch to an unprofitable program. 2.6 Trillion in excess reserves * 0.5% (IOR) = 13 Billion. $300 Billion is the cap eligible for the RRP. $300 Billion * 0.25% = $750 Million.

    And if the range for the RRP and IOR is 4.75% and 5.00% respectively the program will cost $144.25 Billion.

    There is no way that these two tools (IOR & ON RRP) will do this alone with draining some of the excess reserves from the system. Especially when someone like future president Trump gets wind of this.

    1. edit: There is no way that these two tools (IOR & ON RRP) will do this alone WITHOUT draining some of the excess reserves from the system.

  3. I followed the link from FT Alphaville. I am afraid I find this post a bit confusing.

    I don't think the Fed routinely "sold bonds" to tighten money market conditions. Coupon passes were used to handle the underlying gradual rise in the base money supply, and "repos" and "matched sales and repurchases" used to adjust money market conditions to target the effective Fed funds rate in the short term. Meulendyke is the classic on this.

    What the Fed describes as reverse repo, any other money market institution in the Fed's position would call repo - ie the Fed is borrowing from the money market, effectively by simultaneously selling a security to a money market counterparty and buying it back for settlement at a later date (ie a "repurchase" agreement).

    Anyway, given that the money market is massively long reserves, it seems to me that the sensible way to proceed would be to simply move to adjusting the return on reserves and forget the Fed funds market, which is presently rather meaningless. The Fed's RRP facility is just a way of paying the Fed fund rate to non-bank holders of positive current account balances at the Fed - aka reserves. In fact, if the Fed is going to do that, it might as well just pay IOR to all holders of reserves, but maybe that would be blocked by stupid politicians!

    1. Tim, I had to look up the term "coupon pass." :)

      As the data I presented above show, the Fed certainly did use repo and reverse repo to fine tune their interventions. My understanding is that they used OMOs as well, but I'm no expert on the actual mechanics of policy implementation.

      In terms of repo vs. reverse repo, they're just labels describing one or the other side of a transaction. The key is the nature of the underlying transaction, not what we label it (though it would be nice if certain conventions were followed of course).

      One reason not to favor IOER as the policy rate is that the FOMC does not have direct control over it -- I believe it falls under the jurisdiction of the BOG.

      Yes, ON RRP is a way to pay interest on reserves to non depository institutions. My own preference would be to let everyone open an account at the Fed, much the way we can do with the US treasury at www.treasurydirect.gov

  4. Thanks for this post. I might even send it to my 1st year macro students for kicks. 305-type kids for sure.

  5. So, author, I read blogs by Sumner, Erdmann and others and they have no clue about the shortage of treasuries. Clearly, a shortage implies price will be stable or generally increase, and yield will go down. Their explanations of yield going down, which they applaud, generally, does not even include the massive demand for long bonds as collateral in the derivatives markets. I wrote on Talkmarkets that bonds are the new gold and of course, they stand to cause ruin to society as banks would be constrained to lend in a negative rate environment. Not sure about that but it seems to be true. Please help :)