How and why the Fed props up rates The market vogue is to obsess about how the Fed is suppressing long-term rates. But for years now, FT Alphaville has been trying to explain why, in reality, Fed intervention is as much focused on propping up short-term rates (preventing them from falling through zero) as it is about keeping longer-term rate expectations anchored. Another point we've also tried to drill home is that central banks all over the world have always depended on repo markets to enforce their rate policies, and that consequently all central banks - especially in a rate hiking cycle that runs against the natural interest rate - are only as effective as the reserve assets they hold. This is whether they target general collateral rates explicitly or not. Indeed, the eurozone's rate fragmentation in recent years had as much to do with the Bundesbank not being able to keep repo rates on German Bund collateral supported - due to a lack of Bund collateral - as it did with the peripheral central banks" need to support distressed peripheral bonds. Of course, when markets are compliant, usually because the natural interest rate matches central policy, it's very easy for central banks to steer private interest rates simply by means of communication and the cost of central bank short-term liquidity. They tend not to have to intervene in public markets very much at all. The marginal liquidity they provide, meanwhile, caters to the endogenous growth needs of the system. But when the natural interest rate deviates from official policy, or official policy is unable to catch up with the natural rate in such a way that it can influence it, this creates a problem. In 2008, as this chart shows, repo rates not only began to disconnect sharply from official rates, but they started to lead them. From late 2008 onwards, consequently, one of the key challenges for the central bank was how to prop these rates up in a way that stopped the vicious cycle associated with a scramble for safe assets, and the deflationary hoarding behaviour this could encourage. The solution they came up with was the creation of a rate floor, by means of the interest on excess reserves (IOER) mechanism. Not only would the IOER ensure - via bank/non-bank arbitrage - that rates would be pinned up above zero, it would provide a useful sterilisation mechanism that would prevent additional liquidity pumped into the system via QE from crowding out even more safe assets. At the time, the Fed failed to explain all of this effectively (possibly because everyone in central banking would have been aware of it already or because a detailed explanation didn't necessarily serve its interests, since the last thing it would have wanted would have been to draw attention to the repo negativity problem). This week, however, we finally have something in the way of a confirmation, thanks to remarks made by Simon Potter, executive vice president of the NY Fed, and head of the markets group which oversees open market operations of this kind. More so, we have some confirmation of the fact that the IOER wasn't necessarily as effective as the Fed had hoped, and that reverse repos (FARPs) are in some way a newly devised mechanism to deal with the failure. Here's the key paragraph with our emphasis: Money market dynamics in recent years generally reflect these changes. In a world with significantly elevated reserve balances and a ¼ percent interest rate paid on those balances, IOER has kept the federal funds rate and other money market rates at positive levels within the FOMC's zero to ¼ percent target range. Contrary to the dynamics one would expect of an idealized perfect market, however, short-term rates have consistently traded at levels below the IOER rate, and Treasury bill and repo rates have occasionally gone negative, particularly when financial stresses increase the demand for very safe assets. Since IOER is available only to depository institutions holding balances at the Fed, many other money market participants cannot access it, either because they don't earn interest on Fed account balances (like government-sponsored enterprises, or GSEs) or don't have Fed accounts at all (like money market funds). Without such access, these institutions may have less bargaining power and may have to leave funds unremunerated at the Fed or place funds in the market at sub-IOER rates. This creates a potential arbitrage opportunity for banks, which can earn a spread between their costs of funds and their earnings on reserves, but not for other cash lenders. However, uncertain or rising balance sheet costs - likely related to new regulatory changes, including higher capital requirements, leverage ratio and liquidity requirements, and changes in the FDIC's insurance fee assessment scheme - may have altered banks" cost-benefit evaluations and tempered their willingness to arbitrage the differences in rates. Additionally, banks are reportedly unable to attract substantial funds because of lenders" concerns regarding credit risks associated with uncollateralized lending and because lenders often distribute their investments among several banks, making their supplies of funds relatively insensitive to the interest rates offered by individual banks. Thus, while banks take some advantage of the arbitrage opportunity, competitive conditions in the unsecured money markets haven't proven strong enough to narrow the spread between the fed funds rate and the IOER rate to very small and stable levels, and the floor on rates that IOER is meant to provide appears soft. And the other extract that's worth focusing on: Reverse repos were initially envisioned to be used as a term, fixed-quantity tool. However, with the necessary operational infrastructure to support reverse repo operations through tri-party arrangements and an expanded set of counterparties now in place, we're focusing on additional ways to tap the capabilities. Specifically, reverse repos with expanded counterparties could also be used in an overnight, fixed-rate, full-allotment facility with same-day settlement that directly targets overnight interest rates. Such a facility - which is essentially an extension of IOER to a broader set of counterparties - might help strengthen the floor and tighten control over short-term interest rates by increasing competition in the market and diverting deposits from banks, potentially improving the integration among the various market segments. Reverse repos with non-banks would remove reserves from the banking system. The TDF and term reverse repos are somewhat parallel tools, in that they were initially envisioned to auction a fixed quantity of term investments (deposits or reverse repos) to bank and non-bank counterparties, respectively, in order to drain reserves. Their capabilities have been tested periodically over the past several years through small-value exercises in order to ensure that they'll be ready to deploy in size if and when needed. Nevertheless, for reasons discussed earlier, achieving an interest rate target through the management of the supply of reserves alone may not offer the best framework for implementing monetary policy in a system with an elevated level of reserve balances. Instead, overnight, fixed-rate, full-allotment reverse repo operations with expanded counterparties, coupled with IOER available to banks, might enhance the Fed's achievement of its policy objectives in this environment. So there you go, you don't need to take it just from us anymore. FARPs are a mechanism designed to help resolve the safe asset squeeze and to reinforce the Fed's rate floor, which the market was increasingly failing to observe. If we factor into our world view this idea of the Fed being more concerned about its ability to support rates than its ability to dish out liquidity, then that puts an entirely different spin on both taper-talk and the FARP announcement, we would argue. We would also contend that the Fed knows full well (judging from Potter's concluding remarks) that extending IOER to non-banks in this way is also the first potential step towards the central bank becoming a universal bank in its own right. But while there's still a lot to learn, the potential addition of an overnight, fixed-rate, full-allotment reverse repo facility offers a promising new technical advance in the Desk's implementation of monetary policy. Used together with IOER, it may strengthen the floor for short-term interest rates and, with it, the Federal Reserve's control of money market rates, by surmounting the competitive and balance sheet frictions seen in money markets and by extending the central bank's payment of interest to a wider universe of relevant counterparties. Improved control over the level of money market rates and reduced volatility of short-term interest rates could enhance the flexibility of the Desk's operational tools, ultimately allowing for a more robust and effective implementation of the FOMC's policy directives both during the rate normalization period and when there is a very large balance sheet. Related links: On the perils of plunging repo rates - FT Alphaville The perils of releasing the repo rate - FT Alphaville Why cutting IOER could be suicidal - FT Alphaville Is QE deflationary or not? - FT Alphaville