Fed admits failure of 'Plan A' to control money market rates, moves back to repos (which was 'Plan A' until 2008)
Hullabaloo in the repo market torpedoed the Interest on Excess Reserves feature, forcing the Fed to return to the future.
With its announcement this morning, the New York Fed confirmed that the Fed's plan A to manipulate federal fund rates in its target range – now between 1.75% and 2.0% – has failed miserably, and that they will switch to plan B to control short-term interest rates. But this Plan B was Plan A that the Fed had routinely used to control short-term interest rates in the period before the financial crisis. Then back to the future.
The "Repo operations" conducted by the New York Fed since Tuesday were overnight repurchase agreements, where in the morning, the New York Fed offers up to $ 75 billion in cash for security at an interest rate within the Fed's target range. The permitted collateral is government securities, agency securities and mortgage-backed securities guaranteed by Government Sponsored Enterprises (GSEs).
These are overnight interest-bearing loans that relax the next morning, with the Fed getting its $ 75 billion cash back and dealers gaining security. Since these operations were conducted every day for the past four days, it is essentially the same $ 75 billion that is recycled every day. The daily amounts are not additive. And these operations have nothing to do with QE.
Back in the day, the New York Fed routinely performed these repo operations. But in September 2008, when Lehman and AIG collapsed, the Fed switched from repo operations to emergency loans, zero interest rates (ZIRP), QE and other tricks and devices. Repos were no longer needed to control prices.
The chart below shows the back end of the repo operations era through 2008. The increase in repo operations after September 1[ads1]1, 2001 occurred when the Fed briefly injected large amounts of cash via repos as funding dried up, and short-term interest rates blew out:
During the September 11, 2001 panic, the Fed conducted these massive repo operations six mornings in a row. Like all repos overnight, these repos are settled the next day, with the Fed getting its money back and with banks getting back security.
This diagram shows the details of these operations. Notice the amounts, reaching $ 81 billion on September 14, 2001. Four days later, the operation was over, markets had settled, overnight funding was plentiful, the Fed was getting its money back, and the dealers were getting back security:
In September 2008, when the US financial system threatened to freeze, the Fed developed new tools on site, including rescue of emergency loans to banks, industrial companies and market players under a variety of programs, and it switched to ZIRP and QE. But it stopped the repo operations because they were no longer needed.
Prior to the financial crisis, there were no surplus reserves, which are deposits that banks park with the Fed to earn interest, have immediate liquidity and meet regulatory capital and liquidity requirements. Profit reserves started up in parallel with QE, reaching the peak in December 2014. Since then, they have fallen by almost half to $ 1.38 trillion.
By paying the banks interest on Excess Reserves (IOER) at a rate equal to the upper limit of the target range, the Fed estimated that banks would ensure that the federal fund rates would be less than IOER. This will keep the federal fund rate within the Fed's target range. This worked until it didn't.
Throughout 2018, federal fund rates jumped along the upper bound of the Fed's target range and occasionally exceeded the limit. The Fed responded several times by adjusting IOs until it was farther and farther below the upper limit of its target range. It worked until it didn't.
And on Monday this week, all the heck broke in the short-term funding market, which is exactly what the Fed needs to keep under control.
Tuesday The New York Fed announced its first repo operation since September 2008. But the size of the financial world has changed over these years: In 2001, the total amount of the Treasury was $ 5.6 trillion. Now it is over four times larger $ 22.6 trillion. Financing everything is a thriving business, and the stakes have increased, the debt has increased, there is more security, and the amounts have become much larger.
If the peak repo day of September 14, 2001, is multiplied by four, in parallel with the growth of the US Treasury, an equivalent repo operation overnight would amount to $ 244 billion. So $ 75 billion this morning is a small fry. In the chart below, over 19 years of repo operations, the thin line on the right represents the last four days:
Just looking at the repo operations for the last 30 days:
Admitting that plan A failed; Plan B is now standard.
So here's what the New York Fed, which handles the repos, announced this morning "to maintain the federal fund rate within the target range":
- Overnight repo operations will continue through October 10; September 23 for "$ 75 Billion"; on the remaining days of "at least $ 75 billion." These repos relax the day after, with the NY Fed getting back cash and dealers getting back security.
- Three 14-day repo operations for "at least $ 30 billion each" (September 24, September 26 and September 27). Each settlement relaxes after 14 days, with the NY Fed getting its money back and dealers getting back security.
- After October 10, 2019, the NY Fed will conduct repo operations “as necessary to maintain the Federal Fund Rate in Target Area. ”
This third point is the admission that the repo facility is now another integral part of the management of short-term interest rates, as it was before September 2008.
St. The Louis Fed proposed already in those months ago.
St. The Louis Fed published two articles on the benefits of a "Standing Repo Facility", the first paper in March 2019 and the follow-up in April 2019. This standing repo facility is now operational, officially the New York Fed as of this morning.
The two important – but "distinct" – motivations for a standing repo facility are, as cited in the follow-up document:
First, the facility can be used to support interest rate control by establishing a repo ceiling, thus protecting against unwanted spikes in money market rates. The use of a roofing tool for this purpose would be seen as strengthening the monetary policy operating regime of the FOMC.
Second, the facility can be used to reduce the demand for reserves for a given interest rate on excess reserve. [19659028] The first motivation is why the NY Fed is using the facility now: to control spikes in money market rates seen last week and to keep the federal fund rate within the Fed's target range.
The other motivation would be to reduce the excess reserves that are probably needed to control the federal fund rate through IOER. These reserves and IOs would be less important, because the repo business is now taking up much of the work of controlling money market rates. And the level of these reserves (currently $ 1.38 trillion) can be further reduced, allowing the Fed's balance sheet to shrink further:
Why the desire to minimize demand for reserves? In short, because it corresponds to the FOMC's stated preference for operating a floor system with a minimum level of reserves needed to allow an effective and efficient implementation of monetary policy: "minimal with large reserves" too short.
So this standing repo facility, as we look at it today, is taking pressure from the reserves, and it is taking the Fed back one step closer to managing short-term interest rates as it used to do before the financial crisis.
Still, the fact that the Fed was suddenly forced by a panic-filled market to leave Plan A and go back to how it used to do it, instead of implementing the transition methodically, on its own, in its gradual way, must have come as a shock.
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