At the end of 2021’s second quarter, the uptake in the Federal Reserve’s Overnight Reverse Repo (ON RRP) jumped to almost $1 trillion, having increased visibly in June from negligible levels since 2018 and an average of $120 billion in previous years. The increased use of the facility has validated the Fed’s concern that the ON RRP has too large a footprint on US money markets, creating potential financial stability hazards. To address this concern, the Fed should abolish the ON RRP and instead launch a Standing Repo Facility (SRF) to strengthen its financial safety net.
Since 2013, the Fed has been conducting ON RRP operations – selling US Treasury bonds with agreed repurchases (typically overnight) to a broad range of financial institutions including banks, primary dealers, government-sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac, and money market mutual funds (MMMFs), which have become the most important users of the facility. The ON RPP was launched, alongside the Interest on Reserves Balances (IORB), to keep the Federal Funds (FF) rate within the target range set by the Fed as an instrument of monetary policy. The IORB – the interest on reserves held at accounts at Federal Reserve Banks – had been expected to provide a floor to the FF rate, but failed to do so, with the FF rate consistently falling below the IORB. Instead, the policy-determined ON RRP rate has come to serve as the “sub floor.”
Since the Great Financial Crisis (GFC), the FF market has been marginalized, becoming a niche for a small group of players. Specifically, the turnover in the FF market has dropped precipitously to $70-$80 billion a day from almost $300 billion a day before the GFC. Thanks to Quantitative Easing (QE), banks hold a tremendous volume of reserves at the Fed – almost $4 trillion at present – earning interest through the IORB. Furthermore, the amount of funds that banks are required to hold in reserve (the reserve requirement) has been cut to zero. Subsequently, most banks have stopped participating in the FF market. Two types of actors have largely taken their place: GSEs – Congressionally-created but privately run corporations meant to enhance credit flows in specific sectors – which by law cannot receive interest from the Fed and are thus willing to lend Fed funds at any rates above zero; and foreign-owned banks which lack stable retail funding bases in the United States and therefore incur no assessment fees from the Federal Deposit Insurance Corporation (FDIC) and are thus willing to borrow Fed funds at any rates up to the discount rate. Moreover, with the FF rate below the IORB rate, foreign-owned banks have been placing borrowed funds as reserves at the Fed, earning practically risk-free arbitrage profits.
Consequently, the FF rate is no longer the benchmark rate reflecting the cost of funds to banks and thus cannot serve as the steering instrument for monetary policy. Several observers, including former NY Fed President William Dudley, have proposed abandoning FF rate targeting in favor of relying on the IORB, which sets the policy-determined ON risk-free rate on which banks can price other short-term rates. Doing so would also bring more simplicity and clarity to the Fed public communication.
In addition to this change, the ON RRP should also be scrapped since it is no longer needed but costs taxpayers money. It was built as an instrument to control the FF rate – but with the FF rate no longer serving its purpose, the ON RRP has lost its raison d’être. Moreover, getting rid of the ON RRP would address the Fed’s fear of getting too involved in the operations of money markets and creating potential financial stability risks. Specifically, during periods of market stresses, the ON RRP could amplify destabilizing runs from banks (customers moving money from banks to MMMFs) or from companies (MMMFs moving money from the commercial paper market to the ON RRP).
Instead, the Fed should establish a Standing Repo Facility (SRF) with a broad range of participants including mutual funds to complement existing repo facilities it has offered to primary dealers and foreign central banks. In the past, a temporary SRF – through which the Fed lends to participants against US Treasuries as collateral – was used by the Fed to provide emergency liquidity, necessary to stabilize disorderly markets in September 2019 and March 2020. Now, the SRF should be made permanent, as proposed by many economists including Fed officials. In fact, the Federal Open Market Committee (FOMC) actively discussed the SRF at their April 2021 meeting. As mutual funds play an increasing role in financial markets, the SRF would strengthen the Fed’s financial safety net, allowing the central bank to directly reach out to those funds without needing to go through banks. Thus the Fed can intervene in a timely manner to relieve market tension, instead of having to react with emergency measures during market crises. Some observers have worried that the SRF would lead to moral hazard—but this is a moot point as moral hazard is already present thanks to repeated rescue operations by the Fed.
In short, doing away with FF rate targeting and the ON RRP while establishing the SRF would simplify Fed monetary policy operations and its public communication as well as allow it to intervene in a timely and effective manner to diffuse market crises.
Hung Tran is a nonresident senior fellow at the Atlantic Council, a former executive managing director at the Institute of International Finance and former deputy director at the International Monetary Fund.
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