Lift off in a world of excess reserves

Lift off in a world of excess reserves and scarce collateral David Andolfatto 12/10/2015

Monetary policy pre-2008 Most Fed liabilities (monetary base) consisted of currency in circulation, small amount held by banks as reserves. Reserves did not earn interest (so, incentive to economize). Banks borrow/lend reserves on overnight federal funds market. Fed influenced FFR by altering supply of reserves (OMOs). Repo and reverse repos were also used to fine tune policy.

Monetary policy 2008 -2015 Note that cuts in FFR were preceded by declines in market rates. Fed started paying IOER 0. 75% in Oct. 2008, raised to 1. 00% in Nov. 2008, cut to 0. 25% in Dec. 2008. QE begins in Nov. 2008, balance sheet now at $4. 5 T. Banks now flush with reserves, with IOER > UST yields. FF market traded thinly with IOER > FFR.

Interest rates during the crisis

Monetary policy going forward Fed wants to maintain large B/S and excess reserves foreseeable future (taper tantrum syndrome? ). Fed wants to keep FFR as “the” policy rate. • There is the question of why we should care about FFR. “New” tool: ON RRP facility (expanded set of CPs). • Essentially a way to pay IOR to people we’re not allowed to. Hope is that ON RRP rate < FFR < IOER.

Repo and reverse repo levels

What could possibly go wrong? ON RRP cap binds, then potential embarrassment. Will uncapped deposit facility with administered rate encourage “flight to safety? ” • USTs are also a flight-to-safety vehicle, but market price adjusts rapidly. • How quickly can ON RRP rate be changed? Even if lift-off is “successful, ” will other rates follow? • If USTs remain scarce, yields may remain low.

Collateral in financial plumbing Increasingly, collateral has regulatory value and underpins wide range of secured funding and hedging (OTC derivatives) tx. UST highly desirable collateral, but 85% parked in central banks, SWFs, insurers, pension funds, etc. Reuse/rehypothecation over collateral critical for “cash equivalence” and source of liquidity. Collateral released in ON RRP will not be rehypothecated. • Outright asset sales may have been better?

Rehypothecation of assets

Asset sales vs reverse repos

Managing lift off Of course, IOER will rise along with ON RRP rate, but what happens if • ON RRP rate > FFR? • UST yields refuse to budge? Support from US Treasury would be nice. • Re: supplementary financing program Sept 2008 (when Fed ran out of treasuries to finance AIG intervention). Fed may want to prepare contingency plan involving outright asset sales.