I was invited recently to take part on a panel discussion
on Modernizing Liquidity Provision as part of a conference hosted jointly by CATO and the Mercatus Center entitled A Fed for Next Time: Ideas for a Crisis-Ready Central Bank. My post today is basically a transcript of the presentation I gave in my session. I'd like to thank George Selgin and David Beckworth for inviting me to speak on why the Fed should create a standing repo facility, an idea that Jane Ihrig and I promoted early last year in a pair of St. Louis Fed blog posts here and here.
In those posts, Jane I argued that the Fed should create a standing repo facility that would be prepared to lend against U.S. Treasury securities and possibly other high quality liquid assets (HQLAs). We distinguished the facility we had in mind from the discount window in two key respects. First, unlike the window, it would restrict collateral to consist only of HQLA; and second, it would grant access to non-depository institutions, in particular, to dealers and possibly even to all the counterparties that are presently permitted to access the Fed's ON RRP facility.
At the time, we motivated the facility as a way for the Fed to conduct monetary policy in a manner consistent with the FOMC's preferred operating framework of ample reserves together with its 2014 Policy Normalization Principles and Plans which stated, among other things, the desire to hold "no more securities than necessary to implement monetary policy efficiently and effectively."
Jane and I speculated that a significant source of the demand for reserves over other HQLAs came from the Global Systemically Important Bank's (G-SIB's) perceived need for resolution liquidity. We reasoned that these G-SIBs might be more inclined to hold higher-yielding HQLAs over reserves if it was known beforehand that the former could be readily converted into reserves on demand at a standing facility at pre-specified terms. At the same time, the facility would provide a ceiling on repo rates and eliminate the need to estimate the so-called "minimally ample" level of reserves. That is, the facility would automatically flush the system with the reserves it needed as reserve supply and demand conditions varied because of adjustments in the Treasury General Account or other economic factors. Finally, we doubted whether the facility would lead to any significant amount of disintermediation as some people feared. In our view, it would serve mainly to cap the terms of trade in a number of over-the-counter (OTC) repo transactions involving Treasury debt.
The title of this session is "Modernizing Liquidity Provision." We're here today, of course, because of the massive Fed-Treasury interventions in response to the COVID-19 pandemic. Jane and I didn't tout the standing repo facility as a crisis tool because we figured that in a crisis, investors were unlikely to have much difficulty in finding buyers of U.S. Treasury securities. Since the 2008-09 financial crisis, we've grown accustomed to the idea of USTs serving as a flight-to-safety vehicle. And, indeed, this seems to have been the case as the present crisis initially unfolded. Bond yields began to drop sharply in Februrary and then again following the Fed's rate cut on March 5, with the 10-year hitting a low of 54bp on March 9.
But then something happened that I don't think anyone was expecting (certainly, I was not). In particular, after March 9, there's clear evidence of selling pressure stemming from what looked like a repo run on treasury securities. That is, for a variety of reasons there was an enhanced demand for cash which, in this instance, led to sales of U.S. Treasuries, depressing their value as collateral--effectively evaporating a significant portion of the supply of safe assets--which led to margin calls, which led to further selling pressure, and so on.
When the Fed cut its policy rate to 10bp on March 16, bond yields continued to rise, with the 10-year hitting almost 120bp on March 18. Bond yields came down only after the Fed intervened first with its discretionary repo operations and then with $1.5T of outright purchases of securities. This episode reminds us again that cash is king in a crisis and that U.S. Treasury securities are not always considered cash-equivalent in a crisis.
A natural question to ask here is whether disruptions like this constitute a policy problem. After all, it's not like bond traders are unfamiliar with the notion of interest rate volatility. When I glance at the data, the absolute size of this volatility seems more or less stable since the mid 1980s. However, because interest rate levels are so much lower today, a 50bp move is quantitatively more significant in relative terms. This wouldn't be much of a problem, in my view, if treasury securities served merely as pure saving instruments. But for better or worse, the UST has evolved over time to become an important form of wholesale money. In particular, it is used widely as collateral in the repo market (the so-called shadow bank sector). Its value as collateral stems in large part from its perceived safety and liquidity. And most of the time, the U.S. Treasury market is liquid. Except for when it isn't, of course. And so the question is, when it isn't liquid, does it matter and, if so, should something be done about it?
My views on this questions are informed by both by theory and from what I know of the history of the U.S. Treasury market (e.g., Garbade 2016). Theory tells us that in a fiat money system, there's no fundamental difference between account entries at the Federal Reserve and (say) at Treasury Direct. They are both electronic ledgers containing interest-bearing accounts. There are legal differences, of course. Only depository institutions have access to Fed accounts, whereas treasury securities can be held much more widely. Treasury securities are more complicated objects because they differ from each other in terms of coupon, time left to maturity, and possibly other characteristics. For this reason, treasury securities, as with most bonds, trade in decentralized over-the-counter markets instead of centralized exchanges.
While OTC markets may have their advantages (they evidently displaced the centralized exchange of bonds in the 1920s), their decentralized structure can be problematic. When investors become fearful, bond dealers and other traders may become unwilling or unable to execute trades, so that meaningful price information is lost. Safe assets may trade at significant discounts or premia, not for any fundamental reason, but simply because liquidity (market participation/communications) has vanished. Such events have implications that extend beyond the treasury market because, as is well-known, the yield on Treasury debt serves as a benchmark for many other financial assets. Unnecessary and avoidable problems in the treasury market can spillover into other financial markets, bringing grief to the broader economy.
From this perspective then, I am led to ask the question: in what world does it make sense to permit risk-free claims to fiat money like treasury securities to suddenly become illiquid? (This question is distinct from the one that asks whether risk-free claims to fiat money should be made illiquid--as in, the issuance of non-marketable debt; see here, for example) There is really no good reason, as far as I know.
I therefore continue to believe that a standing repo facility makes a lot of sense for the U.S. economy. And I again want to stress that this is not an hypothetical proposal. Many of the world's leading central banks operate such facilities. The Fed has had its ON RRP facility in place since 2013. Indeed, the Fed even implemented a repo facility (called the FIMA repo facility) in March of this year where foreign central banks can borrow funds at 25bp above IOER by presenting U.S. Treasury securities as collateral. The same type of facility set up for domestic purposes (ideally with Treasury support) could simultaneously help the FOMC achieve interest rate control, shrink the size of its balance sheet, and prevent unnecessary violent disruptions in the treasury market by setting a corridor around treasury yields at different maturities. The size of the corridor could ultimately be adjusted to help achieve yield curve control if desired. But this is a separate issue, so let me end here. Please feel free to comment below.