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The Fed’s Failed Experiment

Summary:
Last week, on Tuesday September 17 in particular, overnight credit markets were misbehaving. Since then, various folks have been struggling to understand what is going on, with little assistance, apparently, from the Fed, whose job it is to prevent such misbehavior, and to tell us exactly what is going on. Here's what happened. On Tuesday of last week, the market in overnight repos became very tight:The chart shows the repo rate (secured overnight financing rate), the effective fed funds rate, the interest rate on reserves, and the four-week T-bill rate. On September 17, these interest rates were, respectively, 5.25%, 2.30%, 2.10%, and 2.06%. It's important to note that the repo "market" and the fed funds "market" are not markets in the Econ 101 sense. Some repo and fed funds trades are

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Last week, on Tuesday September 17 in particular, overnight credit markets were misbehaving. Since then, various folks have been struggling to understand what is going on, with little assistance, apparently, from the Fed, whose job it is to prevent such misbehavior, and to tell us exactly what is going on. Here's what happened. On Tuesday of last week, the market in overnight repos became very tight:
The Fed's Failed Experiment
The chart shows the repo rate (secured overnight financing rate), the effective fed funds rate, the interest rate on reserves, and the four-week T-bill rate. On September 17, these interest rates were, respectively, 5.25%, 2.30%, 2.10%, and 2.06%. It's important to note that the repo "market" and the fed funds "market" are not markets in the Econ 101 sense. Some repo and fed funds trades are done through intermediaries (tri-party repo for example), but much trading overnight is over-the-counter, that is bilateral exchange. As a result, there is typically dispersion in market prices, and on September 17 that dispersion was much higher than normal. Roughly, repo market trades were between 2.25% and 9.00%, and fed funds trades were between 2.05% and 4.00%. Further, on September 17, the interest rate on reserves was 2.10%. So, apparently, banks holding reserves were foregoing large profit opportunities to lending in the repo market and fed funds market, and fed funds market lenders were similarly lending unsecured overnight and foregoing large profit opportunities to secured lending in the repo market.

The New York Fed attempted to intervene to push down repo rates on September 17 but, due to some unexplained glitch, couldn't do the job. However, Fed intervention continued - it was still happening yesterday:

The Fed's Failed Experiment
Three points to note are: (i) The Fed has now controlled the problem; the repo rate has been brought down, and fed funds are currently trading within the Fed's 1.75%-2.00% target range. (ii) At from $50-$60 billion in repos outstanding on the Fed's balance sheet, this is a large intervention; (iii) Whatever is causing this is persistent; it's not a one-day event.

Why am I saying $50-$60 billion in repo market intervention is large? In the old days, prior to the financial crisis, the Fed controlled the fed funds rate through repo market intervention:

The Fed's Failed Experiment
In the chart, you can see some unusual stuff going on during the financial crisis, but pre-financial crisis, repos outstanding varied between about $20 billion and $40 billion. So, if the New York Fed's lending on the repo market goes from zero to $50 billion in a couple of days, that's a huge intervention relative to what used to happen in normal times.

So, what's going on? Essentially all central banks in countries with well-developed overnight credit markets intervene so as to peg some overnight rate, under a directive from the decision-making body in the central bank. The Fed likes to articulate the directive in terms of a target range for the fed funds rate, and then it's the job of the New York Fed to achieve that target, through whatever means it has at its disposal. So, in terms of the policy directive, which last Tuesday was to target the fed funds rate in a range of 2%-2.25%, the New York Fed failed - but the top of the range was exceeded by only 5 basis points. So why the panic? The Fed's unstated short-run goal is to control all short-term market interest rates. And the repo market is a much larger market than the fed funds market, and potentially more important in terms of the transmission of monetary policy. Further, volatility of any kind in financial markets is typically perceived to be bad. If such volatility can be avoided through central bank intervention, then the central bank should probably do it.

But what caused the spike in the repo rate, and why didn't the New York Fed's ongoing approach to pegging overnight rates work? Sometimes we like to differentiate between corridor systems (e.g. how central banking currently works in Canada) and floor systems (how it currently works in the U.S.). But in any system of monetary policy implementation, the central bank stands ready, typically on a daily basis, to intervene either on the demand side or the supply side of the overnight credit market - basically, either demand or supply is perfectly elastic at the central bank's interest rate target. Before the financial crisis, the Fed intervened on the supply side of the overnight credit market by varying the quantity of its lending in the repo market so as to peg the fed funds rate. Typically, we would call that a corridor system, as the central bank's interest rate target was bounded above by the discount rate, and below by the interest rate on reserves, which was zero at the time. But, the Fed could have chosen to run a corridor by intervening on the other side of the market - by varying the quantity of reverse repos, for example. Post-financial crisis, the Fed's floor system is effectively a mechanism for intervening on the demand side of the overnight credit market. With a large quantity reserves outstanding, those financial institutions holding reserves accounts have the option of lending to the Fed at the interest rate on reserves, or lending in the market - fed funds or repo market. Financial market arbitrage, in a frictionless world, would then look after the rest. By pegging the interest rate on excess reserves (IOER), the Fed should in principle peg overnight rates.

The problem is that overnight markets - particularly in the United States - are gummed up with various frictions. First, fed funds credit is not the same thing as repo market credit. The former is unsecured and the latter is secured with collateral - primarily Treasury securities. The timing can be different for when funds go out one day and are returned the next. Only financial institutions with reserve accounts at the Fed participate in the fed funds market, whereas the repo market has a wider array of participants. Second, there are regulatory constraints. New Basel III requirements, particularly the liquidity coverage ratio (LCR) requirement, constrain banks to holding liquid assets that can finance specified funding outflows, should they arise. Dodd-Frank regulations for systemically important financial institutions have resolution plans that include providing for sufficient liquidity. There are capital constraints, etc. Finally, as mentioned above, much of the trade in overnight credit markets is over-the-counter. Market participants develop long-term relationships with counterparties, but there can be shocks to markets that disrupt those relationships, making it difficult to find a counterparty for a particular desired trade.

Friction in U.S. overnight credit markets, and its implications for monetary policy, is nothing new. Indeed, the big worry at the Fed, when "liftoff" from the 0-0.25% fed funds rate trading range occurred in December 2015, was that arbitrage would not work to peg overnight rates in a higher range. That's why the Fed introduced the ON-RRP, or overnight reverse-repo, facility, with the ON-RRP rate set at the bottom of the fed funds rate target range, and IOER at the top of the range. The idea was that the ON-RRP rate would bound the fed funds rate from below. During 2016, these were the paths of short-term interest rates:

The Fed's Failed Experiment
Until the December 2016 meeting, the ON-RRP rate was set at 0.25% and IOER at 0.5%. But the fed funds rate was 9-12 basis points lower than IOER, and the one-month Treasury bill rate was typically in the 0.1% to 0.3% range. As well, note the downward spikes in the fed funds rate, which occur at month's end. There were some stories to explain that configuration of interest rates, but in retrospect, I'm not sure any of those make sense. ON-RRP intervention by the Fed looks like this:
The Fed's Failed Experiment
That chart isn't picking up everything, as it's only for Wednesdays, but this gives you some idea what was going on. This makes the recent repo intervention by the Fed (on the other side of the market) look small. Until early 2018, it was considered normal for the takeup on the ON-RRP facility to be anywhere from $100 billion to $200 billion each day, with spikes of $500 billion or $600 billion (not in the chart, as again it's only Wednesdays) at the end of the quarter. This was basically borrowing by the Fed on the repo market to hold up the repo rate.

But note that, in early 2018, the ON-RRP facility became moribund - zero takeup essentially. What happened then?

The Fed's Failed Experiment
During 2018, the Fed's floor system actually seemed to have been working properly. Particularly in the September-December 2018 period, IOER appeared to be pegging the fed funds rate, the repo rate, and the one-month T-bill rate - arbitrage seemed to be working. But, beginning in 2019, funny things started happening in the repo market. Those downward month-end spikes in the fed funds rate that you can see in the 2016 data started to appear as upward month-end spikes in the repo rate. The one at year-end 2017 is particularly large. As yours truly pointed out (with some prescience) in May of this year,
Well, it appears there is something wrong with the Fed's ability to control short rates. I'm actually less concerned with the fed funds rate, and more concerned with repo rates, as the Fed should be. Those end-of-month spikes in repo rates shouldn't be happening.
There's something else that's odd in the last chart, which is that the one-month T-bill rate has dropped below the interest rate on reserves, even if you account for market anticipation of Fed rate cuts.

So, how to make sense of this? There are several aspects of the problem we need to be concerned with:

1. Every central bank needs to be concerned with fiscal authority actions. For example, if the fiscal authority holds its available cash as deposits at the central bank, then inflows into that deposit account due to tax receipts or government security issuance have monetary implications. There has to be a mechanism in place to deal with that. For example, the Bank of Canada auctions these funds off in the repo market.
2. Large scale asset purchases (QE) by the Fed had, and have, implications for how the overnight market works.
3. How do new bank regulations (LCR and resolution liquidity) matter?
4. Central bankers, for good reasons, want to project confidence, and they don't like to admit errors. Large scale asset purchases were a large-scale experiment, and there appear to be no strong voices on the FOMC that question the efficacy of QE, and the current floor system. Indeed, the committee decided early this year to stick with the floor system indefinitely, and the revinvestment program, that replaces Fed assets as they roll off, was resumed in August. Given this, you'll find plenty of Fed employees - management, economists - supporting the party line. If there are no good reasons for justifying a large balance sheet indefinitely, folks at the Fed will make them up.

Let's start with fiscal actions and how they matter here. Here's the Treasury's general account with the Fed.

The Fed's Failed Experiment
Before the financial crisis, Treasury parked its deposits in the private sector - so that inflows and outflows from those accounts wouldn't mess with monetary policy. You'll notice that, after the financial crisis, the balance in the Treasury's general account became substantial, and became quite large on average in 2016, and much more volatile. Recently, this account balance has been anywhere between $38 billion and $420 billion. Note that, if total reserves outstanding are constant and general account balances go up, then reserve balances held in the private sector must go down by the same amount. The Fed permits these large and fluctuating Treasury balances, apparently because they think this won't matter in a floor system, as it shouldn't. But, if anyone at the Fed suggests that the answer to the problem highlighted by the repo market dysfunction last week is to purchase more assets, someone should tell that person that if the problem is too little reserves, more reserves can be had if the Treasury parks its deposits in the private sector, just like in the old days.

Another drain on private sector reserve balances is the foreign repo pool:

The Fed's Failed Experiment
This balance isn't as volatile as the Treasury general account, but it's large and growing, and it's unclear what its purpose is. Like the Treasury account, it's purely discretionary. The Fed once had caps on this, which for some reason were lifted. All very murky. Some of this could be foreign governments and central banks which are permitted by the Fed to hold what are effectively interest-bearing reserve balances at the Fed - much more attractive than previously given low or negative government security yields in other countries. But again, if the problem is low reserve balances in the private sector, those balances could be increased by about $300 billion if the Fed eliminated the foreign repo pool.

Some people blame new bank liquidity requirements, at least in part, for the repo fiasco last week. The problem here is that, for both LCR and resolution liquidity requirements, Treasury securities and reserves are essentially equivalent - both are high-quality liquid assets (HQLA). Thus, if the problem is that liquidity is being hoarded, creating pressures in the repo market, it's a dearth of Treasuries plus reserves that's the problem. That can't be fixed by having the Fed swap reserves for Treasuries - that has zero effect on the total. Some people have tried to make the case that reserves are somehow significantly superior liquid assets to Treasury securities, and that liquidity requirements have increased the demand for reserves in particular. But that notion is inconsistent with what we see in the data. As I pointed out in this blog post, banks have accumulated a lot of Treasuries, and a lot of reserves, but are not demanding a premium in the market to hold Treasuries - indeed, it's currently the other way around. That is, T bill rates are below IOER.

In the past, I've made the case that QE causes dysfunction in overnight markets. In the 4th chart above, the 2016 interest rate data can be viewed as reflecting a collateral shortage in the overnight market. That's what kept the Fed's ON-RRP program alive. The Fed had sucked up a large fraction of the securities useful as collateral in overnight markets, so that it could turn around and borrow in the overnight repo market - at a rate below IOER. That shortage appears to have gone away in early 2018. But one might then expect that, with plentiful collateral in overnight markets, that things would settle down. But now there appears to be sporadic high demand for overnight loans in the repo market, and things are going the other way.

What I'm leading up to is the conclusion that we shouldn't characterize the problem here as a "scarce reserves," particularly as some seem to think that implies the Fed needs to buy more assets. The key problem is that the Fed is trying to manage overnight markets by working from the banking sector, through the stock of reserves. Apparently, that just won't work in the American context, because market frictions are too severe. In particular, these frictions segment banks from the rest of the financial sector in various ways. The appropriate type of daily intervention for the Fed is in the repo market, which is more broadly-based. If $1.5 trillion in reserve balances isn't enough to make a floor system work, without intervention through either a reverse-repo or repo facility, then that's a bad floor system.

The arguments for having a large Fed balance sheet are two-fold. First, it's supposed to make monetary policy implementation easy. Just set IOER, and arbitrage looks after the rest. Second, Fed asset purchases are supposed to be "stimulative," increasing inflation and aggregate economic activity. Well, apparently, the first argument is wrong - nothing easy about this at all. In this respect, the implementation has left people scratching their heads and wondering if the people at the New York Fed and the Board have their heads screwed on properly. On the second, there's no evidence that QE is helpful in achieving any of the Fed's ultimate goals, and it may just be harmful, in that the Fed swaps inferior reserves for superior Treasury securities. The reserves are crappy assets because they're only held by a segment of financial institutions, and because of the market frictions I've been discussing. If the Fed takes away good collateral and gives the financial market crappy assets, nothing good happens.

Conclusion? For now, the Fed needs to be intervening in the repo market on a regular basis, and it's possible that the intervention could go back to the other side of the market, with an active ON-RRP facility. Intervention - either way - should be at IOER. None of this target range nonsense. In the long run, the Fed should get rid of the large balance sheet. Please. Make the secured overnight financing rate the policy rate, and run a corridor system. That's what normal central banks do.

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