The Hullabaloo on the repo market torpedoed the function of interest on surplus reserves, forcing the Fed to return to the future The federal interest rate – now between 1.75% and 2.0% – has failed miserably and is on Change plan B to control short-term interest rates. However, Plan B was Plan A, routinely used by the Fed to control short-term interest rates in the pre-financial crisis. So back to the future.
The New York Fed's "repo transactions" since Tuesday were overnight repurchase agreements, with the New York Fed offering up to $ 75bn in cash as collateral at an interest rate this morning, which is within the Fed's target corridor , The eligible collateral is treasury bills, agency securities and mortgage-backed securities guaranteed by Government Sponsored Enterprises (GSEs).
These are interest-bearing overnight loans that will be released the next morning and that will give the Fed its $ 75 billion in cash, and the traders will get their collateral back. Because these operations have been done every day for the last four days, essentially the same $ 75 billion a day is recycled. The daily amounts are additive not . And these operations have nothing to do with QE.
Earlier, the New York Fed routinely performed these repo operations. In September 2008, when Lehman and AIG collapsed, the Fed switched from repo transactions to rescue loans, ZIRP (zero interest rate policy), QE and other tricks and instruments. Repos were no longer needed to control interest rates.
The graph below shows the end of the era of repo operations in 2008. The increase in repo operations after September 1
1, 2001, occurred when the Fed temporarily injected massive amounts of money into repos as funding dried up and short-term interest rates flourished:
During the September 11, 2001, panic, the Fed carried out these massive repo operations six mornings in a row. Like all overnight repos, these repos are canceled the next day, with the Fed getting their money back and the banks getting their collateral back.
This chart shows the details of these operations. Note the amounts that reached $ 81 billion on September 14, 2001. Four days later, the operations were over, the markets had calmed down, there was plenty of overnight money, the Fed got their money back and the traders got back their collateral:
In September 2008, when the US Threatened to freeze financial system, the Fed developed new local tools, including rescue loans for banks, industrial companies and market participants under various programs it shifted to ZIRP and QE. But it stopped the repo operations because they were no longer needed.
Prior to the financial crisis, there was no excess reserves, ie deposits that banks park at the Fed to earn interest, be immediately liquid and meet regulatory capital and liquidity requirements. In excess of QE, excess reserves accumulated and peaked in December 2014. Since then, they have fallen by almost half to $ 1.38 trillion.
By paying interest rates on excess reserves (IOER) at the upper rate The Fed expects banks to ensure that federal interest rates are below the IOER. This would keep federal interest rates within the Fed's target range. This did not work until then.
During the course of 2018, the federal interest rate limped along the upper limit of the Fed target range and occasionally crossed the upper limit. The Fed responded several times by setting the IOER below the upper limit of its target corridor. That worked until it did not work.
And on Monday this week, all sorts of things have happened on the short-term refinancing market, and this is exactly what the Fed should be able to control.
On Tuesday The New York Fed announced its first repo since September 2008. But the scale of the financial world has changed in those years: in 2001, total government bonds totaled $ 5.6 trillion. Now it is four times bigger [$19459008] $ 22.6 trillion. The financialization of everything is a booming business, and the stakes have increased, the debts have become bigger, there is more collateral, and therefore the amounts have become much larger.
If the peak repo day on September 14, 2001 is multiplied by four, an equivalent daily repo would amount to $ 244 billion today, in line with US government bond growth. The 75 billion dollars this morning are so little roast. In the following graph of 19 years repo operations, the thin line on the right represents the last four days:
Considering only the repo transactions of the past 30 days:
 Admit that Plan A failed; Plan B is now standard.
The New York Fed, which manages the repos, announced this morning:
- overnight repo operations will continue until October 10; on September 23 for "$ 75 billion"; on the remaining days for "at least $ 75 billion". These repos are canceled the next day, with the New York Fed receiving cash back and traders getting their collateral back.
- Three 14-day repo transactions for "at least $ 30 billion each" (24 September, 26 September and 27 September). Each is wound up after 14 days, with the New York Fed getting their money back and the traders getting their collateral back.
- After October 10, 2019, the New York Fed will conduct repo operations as needed to help maintain US Federal Reserve benchmark interest rates.
This third point is the admission that the repo facility is now again an integral part of the management of short-term interest rates, as it was before September 2008.
The St. Louis Fed already suggested these months before.
The St. Louis Fed has released two publications on the benefits of a "Standing Repo Facility," the first publication in March 2019 and the follow-up in April 2019. This Standing Repo Facility is now operational and has been officially recognized by the New Yorkers Fed from this morning.
The two main motives for a standing repo facility are, as cited in the successor paper:
Firstly, the facility could be used to support interest rate control by setting an upper limit on repo rates, thus protecting you from unwanted money market interest rates. The use of an upper limit tool for this purpose would be seen as an improvement in the monetary policy functioning of the FOMC. Second, the facility could be used to reduce the demand for reserves for a given excess reserve.  The first motivation is why the New York Fed is taking advantage of this opportunity: to control the money market rates seen last week, and to keep federal interest rates within the Fed's target range.
The second motivation would be to reduce the excess reserves that are likely to be needed to control the federal rate over the IOER. These reserves and the IOER would lose importance as repo transactions now take up much of the money market rate control work. And the amount of these reserves (currently $ 1.38 trillion) could be further reduced, which could further reduce the Fed's balance sheet:
Why the desire to minimize the demand for reserves? In short, because it is in line with FOMC's declared preference to operate a flooret system with the minimum reserve ratio required for the efficient and effective conduct of monetary policy: "In short, minimal sufficient reserves".
As we see it today, it relieves these reserves and brings the Fed one step closer to short-term interest rate management, as it did before the financial crisis. Nonetheless, the fact that the Fed was suddenly forced by a panicky market to abandon Plan A and return to its previous course of action rather than implementing the transition methodically and gradually on its own, has been a shock.
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