The murder of the repo market torpedoes the function of interest on excess reserves and forced the Fed to return to the future.
With their announcement this morning, the New York Fed confirmed that the Federal Reserve A's plan to manipulate federal funds' interest rates in their target range – now between 1.75% and 2.0% – has miserably failed and that will move to plan B for controlling short-term interest rates. But this plan B was plan A that the FR routinely used to control short-term interest rates in the pre-financial crisis era. So back to the future.
The "repo" of the Fed in New York on Tuesday was a one-night buy-back contract where in the morning the New York Fed offered up to $ 75 billion in cash for interest rate security, which is within the Fed's target range. Permitted collateral is government securities, agency securities and mortgage-backed securities guaranteed by government sponsored enterprises (GSEs).
These are overnight interest loans, which are issued next morning, with the Fed receiving its $ 75 billion in cash back and dealers getting their collateral back. Since these operations have been undertaken every day for the last four days, they are essentially the same $ 75 billion recycled every day. The daily quantities are and not additive. And these operations have nothing to do with QE.
In the meantime, the New York Fed routinely used these repo operations. But in September 2008, when Lehman and AIG collapsed, the Fed switched from repurchase operations to emergency loans, ZIRP, QE, and other tricks and gadgets. Reposts were no longer needed to control rates.
The chart below shows the end of the era of repo transactions in 2008. The surge in repo operations after 9/1
During the panic on September 11, 2001, the Fed conducted these massive repo operations six mornings in a row. Like all repo overnights, these re-habits develop the next day, with the Fed getting its money back and the banks getting their collateral back.
This diagram shows the details of these operations. Look at the sums of $ 81 billion on September 14, 2001. Four days later, operations closed, markets calmed down, overnight funding was plentiful, the Fed received its money back, and dealers received their collateral back:
In September 2008, when the US financial system was threatening to freeze, the Fed developed new on-site instruments, including emergency rescue loans for banks, industrial companies and market participants under various programs, and it switched to ZIRP and QE. But he stopped the repo operations because they were no longer needed.
Prior to the financial crisis, there were no excess reserves, which are deposits that banks park in the Fed to earn interest rates, have immediate liquidity, and meet regulatory capital and liquidity requirements. Excess reserves began to accumulate in parallel with QE and peaked in December 2014. Since then, they have fallen by nearly half to $ 1.38 trillion.
By paying banks interest rate on excess reserves (IOER) at a rate equal to the upper limit of its target range, the Fed estimates that banks will ensure that the federal funds rate is lower than IOER. This would keep the size of federal funds within the Fed's target range. This works until it happens.
Throughout 2018, the percentage of federal funds rotated above the Fed's target range and sometimes exceeded the limit. The Fed has responded several times by adjusting the IOER where it is further and below the upper limit of its target range.
And on Monday this week, the whole hack fell into the short-term financing market, which is exactly what the Fed needs to be able to keep under control.
On Tuesday, the New York Federation announced its first repo operation since September 2008. But the size of the financial world has changed over the years: In 2001, the Treasury's total debt was $ 5.6 trillion. Now it is over four times the size of $ 22.6 trillion. Financing everything is a thriving business and bets have increased, debt has become larger, there are more collateral and so the amounts have become much larger.
If the peak of the repo repo on September 14, 2001 were multiplied by four, in parallel with the US Treasury's debt increase, an equivalent repo operation overnight would amount to $ 244 billion today. So $ 75 billion this morning is small fries. In the chart below of 19 years of repo transactions, the thin line to the right represents the last four days:
Just a look at the repo operations over the last 30 days:
Recognizing that plan A failed; Plan B is now standard.
So here is what the New York Federation, which deals with reposts, announced this morning "to help keep the federal interest rate within the target range":
- Repo overnight operations will continue until October 10; on September 23 for $ 75 billion; in the rest of the day for "at least $ 75 billion." These reports unfold the next day after the NY Fed receives the money back and the dealers receive their security back.
- Three 14-day repo transactions for "at least $ 30 billion each" (September 24, September 26 and September 27). Each is unwound after 14 days, with the NY Fed receiving the money back and the dealers receiving their security back.
- After October 10, 2019, the NY Fed will conduct repurchase operations "as necessary to help maintain the federal rate of funds in the target range. "
This third point is the recognition that the repo facility is once again an integral part of short-term interest rate management, as it was before September 2008.
The St. Louis Fed has already proposed this month
The St. Louis Fed publishes two documents on the benefits of the Permanent Repo Mechanism, the first in March 2019 and the follow-up in April 2019. This operating repo facility is already in operation, officially authorized by the New York Federation this morning.
The two key but "separate" motivations for a standing repo facility are as set out in the following document:
First, the facility can be used to support interest rate control by setting a repo rate ceiling, this is to prevent unwanted spikes in money market interest rates. The use of a ceiling instrument for this purpose would be seen as an improvement in the FOMC's monetary policy regime.
Secondly, the mechanism can be used to reduce the demand for reserves for any given interest rate on excess reserves.  The first motivation is why the NY Fed is using the mechanism now: to control the jumps in money market interest rates, as seen last week, and to keep the federal funds within the Fed's target range.
The second motivation will be to reduce the excess presumptive reserves required to control the size of federal funds through the IOER. These reserves and the IOER would become less important as repo operations now take a large part of the work to control 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 reduce demand for reserves? In short, it is in line with FOMC's stated preference for managing the floor system with the minimum level of reserves required to allow the effective and efficient conduct of monetary policy: "minimum reserves" for short.
So this constant repo instrument, as we look at it today, puts pressure on those reserves, and this takes the Fed back one step closer to managing short-term interest rates than it did before the financial crisis.
Notwithstanding the fact, he was suddenly forced by the panic-stricken market to abandon Plan A and return to the way it did, rather than apply the transition methodologically, in itself, it must gradually become a shock.
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