In response to the apparent enthusiasm in the latest FOMC minutes for cutting the interest paid on reserves, we noted last week that the Fed would likely wait for certain conditions to be met before taking this step, if it ever does. Those conditions are: 1) The Fed's proposed new reverse repo facility is up and running, 2) It's clear that the new reverse repo facility has successfully established a floor under general-collateral overnight repo rates, and 3) At no point does it seem as if either secured (GC repo) or unsecured (effective federal funds) rates were threatening to turn negative and lead to the attendant disruption of money markets. Again, this is all just speculation. But given the many variables involved, we're guessing that the Fed would only take such a step very gingerly - lowering rather than eliminating IOER, and possibly even targeting a slightly higher overnight repo rate (through a high enough reverse repo facility rate) just to be safe. The way to think about this is that right now the payment of IOER is supporting both unsecured rates (directly) and secured rates (indirectly, though competition with the de facto provision of collateral that it represents). By lowering IOER while simultaneously targeting higher repo rates, the Fed would be modestly reducing support for unsecured rates while modestly increasing its support for secured rates, and the two would compress further. But recently we've come across research notes from Goldman, Citi and RBC strategists all expressing scepticism that the Fed would take even a minor step in this direction. We summarise the reasons for scepticism as follows and then excerpt from the notes at the end of this post: 1) Because banks are charged an FDIC fee on deposits, they might implement a negative deposit rate if the IOER is set too low. This wouldn't just place downward pressure on all short rates (such as T-bill and repo, as investors chase other short-term investments and sources of yield), but might also bring about the unpredictable consequences of financial disintermediation if negative rates did lead to depositors exiting and holding more paper money. 2) The downward pressure on US deposit rates might be unexpectedly large if foreign banks, which aren't subject to the FDIC fee and already hold more than $1 trillion in reserves, stop adding to their reserve holdings and US banks take up the slack. This is a problem not just because of the downward pressure on rates, but also because forthcoming capital requirements under Basel (6 per cent of reserves for the big banks, less for smaller banks) could mean tighter lending conditions at banks with high levels of reserves. 3) Because a lower IOER would shrink the spread between the effective federal funds rate and the IOER, some banks could leave the federal funds market (which is already thinly traded), concentrating the market share of those remaining. RBC Capital Markets strategists note the possibility that some of these remaining banks wouldn't want the reputational risk associated with this increased relative presence, and therefore they too would leave, further concentrating market share, and so on. This would likely shrink volumes even further. 4) The Fed's reverse repo facility remains in its testing phase; it isn't yet ready. 5) Even when it's finally ready, the Fed might be hesitant to experiment both with cutting IOER and with ramping up the reverse repo facility at the same time: too many unknowns. 6) Even if the facility does work, it might not be enough off an offset. Maybe it can floor repo rates. But as noted above, it can't stop deposit rates going negative if IOER is set too low. Furthermore, once the facility is up and running, it may take a while for the Fed to learn just how demand for it by money market counterparties will shift in response to economic and financial conditions, and how to appropriately change the rate in response. 7) The Fed's enthusiasm about cutting IOER has been overstated. According to the minutes, "most participants thought that a reduction by the Board of Governors in the interest rate paid on excess reserves could be worth considering at some stage, although the benefits of such a step were generally seen as likely to be small except possibly as a signal of policy intentions." This may represent a revived willingness to contemplate a cut, but it's far from a definitive signal of intent. Given the problems listed above, the communications challenge of explaining the purpose of a "fixed-rate full-alottment revere repo facility," and the probable slightness of any economic benefits, the risks might not be worth it. All good points. Of course, the question of what the Fed should do is a separate from the question from what it will do. Nobody knows the answer to the latter, and the answer to the former is highly contestable. We have no idea what the Fed will choose, but we still think that a small reduction in IOER following the establishment of the reverse repo facility would be manageable without sending money market participants into a collective panic. It's not unreasonable to think that a floor on repo rates established by the reverse repo facility would mean a smaller burden on IOER to bolster all short rates. We do take seriously the possible consequences of deposit rates going negative, and federal funds rate trading volume plummeting, if IOER is too low. But we doubt the Fed would be reckless enough to start by lowering the rate so much that this threat would materialise. Yet we could be wrong. And we do agree both that such a move would produce only a modest economic benefit at best, and that the Fed has better tools at its disposal if it wants to strengthen its commitment to loose policy: another delay of the taper, a lower threshold for unemployment, a new lower bound for inflation - not to mention moving towards a bolder regime change. Right now it seems as if the purpose of a cut would be to paper over the taper - to once again reinforce the notion that slowing the pace of asset purchases does not signal a general loosening of policy. As Gavyn Davies explains, the Fed appears to already be succeeding in this goal. An IOER cut may help further, but probably not by much. Regardless, it seems that soon the Fed will effectively continue using three rates in combination as its policy rates: the targeted federal funds rate range, which the public still interprets as the Fed's main policy tool; the reverse repo rate because it allows greater control over collateralised rates in a collateral-constrained world; and the IOER rate to complement the reverse repo rate in keeping unsecured rates in line with secured rates if they begin to diverge. Something we haven't yet worked out is why the development of this reverse repo facility is preferable to simply extending IOER to the same wider list of counterparties that will have access to the facility. It would be simpler, the Fed wouldn't need to depend on having certain kinds of assets on its balance sheet with which to reverse repo, and would serve much the same purpose of controlling rates in an era of big reserves. A lower IOER rate could similarly be offset by the bigger counterparty list. Goldman economists reckon that the reverse repo facility would revitalize collateral circulation. But according to Manmohan Singh, that's not right: the Treasuries and agency MBS used in the reverse repo operations would not be rehypothecable. One possible reason is that IOER, despite its usefulness as a tool for converging and controlling rates, has become stigmatised as a Fed subsidy to the banks. Extending it to more counterparties might seem like Fed overreach into the marketplace. In practice, the reverse repo facility wouldn't be any different in this regard, but "fixed-rate full-allotment reverse repo" is a convoluted technical phrase that few people understand, while "paying interest" is universal. Hard to say - lots of moving parts here. RBC Capital Markets: 1) The fed funds cliff In the wake of the Libor scandal, there is significant reputational risk for any bank that becomes a large share of the market for a benchmark rate. Volume in the Fed funds market is low, and is dominated by a single GSE lending to banks who leave the cash at the Fed and earn the spread between Fed funds and IOER. If IOER was cut even modestly, the reduced spread between fed funds and IOER may cause some banks to exit the Fed funds market. This would push up the market share and the resulting reputational risk for the remaining participants, which could cause some of them to exit. That drives up the market share and reputational risk for the remaining players, causing a spiral that very quickly turns volume in the Fed funds market to vapor. We have no idea what level of IOER causes these nonlinear effects on the fed funds market, and neither does the FOMC. But given the fact that OIS is now used to discount swaps, taking a risk that could make Fed funds even more of a mythical rate would be irresponsible. 2) Basel is about to make reserves very painful, so US regulators want foreign banks to hold reserves. Right now foreign banks hold about 50% of the $2.5T in reserves outstanding even though their asset base is only about 1/5th that of Domestic banks. They do so for two reasons. For some reserves are a more attractive liquid asset for regulatory purposes than they have available in their home country. And some can borrow in the dollar markets at very low rates and earn a spread between that rate and IOER. If IOER is cut, we should see less foreign bank interest in holding reserves. And since those reserves must go somewhere, they will flow to US banks. Under Basel, large US banks will need to hold 6 percent capital against reserves, and small banks will probably need to hold 3 percent capital. A massive amount of bank capital will get utilized financing the Fed's QE program (which is effectively what a reserve is) rather than making loans, buying securities, or anything that might help economic growth. The negative economic impact of this regulation is worse the higher the percentage of reserves held by US banks. So if a lower IOER means foreign banks hold less reserves, then the bank capital effect means lower IOER means tighter financial conditions rather than looser financial conditions. The same Basel bank capital issues are going to make QE even less helpful to economic growth. 3) Negative deposit rates create odd payments systems flows. The RRP facility could be used to keep repo rates above zero, but it won't help keep bank deposit rates above zero. And negative rates encourage people to prepay bills to take advantage of the negative float, which creates a variety of odd credit risks, etc. The RRP facility is not necessarily a cure-­‐all As we discussed above, the reverse repo program does not clear up all of the technical issues that would follow an IOER cut. In fact, there are issues that could arise if the reverse RP program was large, which it would need to be if it was going to boost market rates relative to IOER. Most counterparties that are perceived to be better credits see huge demand from customers looking to invest cash over quarter ends, etc. If this window dressing demand is combined with the ability to invest at the Fed at fairly competitive rates, quarter end financing squeezes could be more significant for counterparties that are perceived to be worse credits. Another way of thinking of this is that every dollar the Fed takes in from money funds is a dollar of financing another party does not have. All of this means that a RRP rate that is appropriate for an average day will be way too high for days when window dressing behavior is high. It is going to take the Fed a very long time to learn how demand shifts, so they can adjust the rate to keep financing conditions stable. Jumping straight into an RRP program large enough to offset the impact of a meaningful cut in IOER is likely to be bumpy. And limiting an IOER cut to the small amount that avoids this risk (or the negative deposit rate risk) would leave the public wondering what the point was of a tiny IOR cut. Goldman: The fixed-rate full-allotment facility is not ready. Some have argued that the Fed could potentially offset these disadvantages by flooring short-term rates with its proposed fixed-rate full-allotment reverse repo facility. While testing has been fairly extensive to date, we think the facility―currently with a maximum capacity of $139 billion and an average daily usage of $3 billion over the past week―is still due for more extensive testing in the Fed's eyes before being brought to full-allotment in an environment with more than $2.4 trillion in excess reserves. In addition, we think that the Fed would be unlikely to experiment with two changes likely to have substantial impacts on money market equilibria―cutting IOER potentially to zero and bringing the reverse repo facility to full allotment―simultaneously. Negative impact on depositors. Cutting IOER, in particular to zero, could prompt charges (effective negative interest rates) on bank deposits, in particular in light of the FDIC's fee assessed on deposits. We think that the qualitative difference between earning zero on one's money and being charged to keep money in the bank may be significant. Although unlikely under a scenario of only modestly negative effective interest rates, in the extreme it is possible that demand for physical currency could increase coincident with deposit outflows, a scenario that we expect the Fed would find highly concerning. Not necessary to offset tapering. In our view, if the Fed is looking for a simulative offset to an eventual tapering in the pace of its asset purchases, enhancing the forward guidance by reducing the unemployment threshold to 6.0% offers a much more compelling risk/reward tradeoff. Citi: Countervailing potential benefits are several costs. Currently US banks rely on parking cash at the Fed as a way to generate income on deposits. While IOR is 25bp, US banks are charged an FDIC fee on assets, including reserves held at the Fed meaning the net return on placing cash at the Fed is below 15bp. Even a partial decrease in IOR, say to 12.5bp, would leave US banks earning very close to 0bp, net of FDIC fees, on cash placed at the Fed. With the prospect of losing money on each new dollar deposited, banks may pay negative rates on deposit accounts. Tbill and repo rates would move lower along with deposit rates as investor cash would seek out alternative short-term investments. While depositors might be willing to accept a modest negative rate as a "safe keeping" fee, there is a risk that if deposit rates became sufficiently negative, some investors might seek to hold more cash in the form of paper currency, disintermediating the traditional financial sector entirely. The Fed has in the past expressed concern about the significant unknowns around such a scenario. Foreign banks would also be directly impacted by a cut in IOR. As we have previously discussed, foreign banks, not subject to the FDIC fee, hold more Fed reserves today than US banks. They engage in the so called "Fed arb," issuing CP and CDs at, for example, 10bp and earning 25bp at the Fed. Hence a cut in IOR would make the "Fed arb" trade less attractive, leading foreign banks to reduce issuance of CDs and CP. If IOR was reduced to 0bp, CD and CP rates would have to move negative to induce foreign banks to hold on to their over $1 trillion in reserves. Since the total quantity of reserves in the banking system is essentially fixed by the Fed, to the extent foreign banks reduce reserve holdings, US banks would have to increase reserve holdings, placing further downward pressure on US deposit rates. Money market mutual funds (MMF) might have more difficulty navigating very low or negative rates than banks. Whereas banks can at least in theory pay negative rates on deposits, the MMF business model is based on full return of principal. If banks reduced deposit rates, MMF might be faced with the prospect of inflows of cash in an environment of close to 0bp or negative short-term rates. This could lead some MMF, particularly government MMF that only invest in government related securities like T-bills and Treasury repo, to close to new money. The risk of disturbances in money markets was a consideration when the Fed decided against lowering IOR in the past. Related links: Why the Fed can begin lowering IOER soon (maybe) - FT Alphaville Will this be the ZLB/repo/collateral-scarcity solution we've been waiting for? - FT Alphaville Towards a widow's cruse economy - FT Alphaville Matched-book repo and the continued shadow crunch - FT Alphaville The shadow banking system, crunched one way or another - FT Alphaville