The Federal Reserve will make greater use of its reverse-repurchase agreement facility while policy makers shift focus to rate guidance from asset purchases, according to the central bank’s former markets group head.
“I would expect the Fed to increase the size of this facility, and even to get to full-allotment operations, over the course of this year,” Brian Sack, co-director of global economics at D.E. Shaw & Co., the $32 billion hedge fund, and former head of the Federal Reserve Bank of New York markets group, said during a telephone interview Jan. 31. “This would be a prudent step if this facility is going to be a key part of the Fed’s operating framework.”
Fed policy makers last month extended for a year tests of the overnight fixed-rate reverse repurchase agreement program begun in September. The maximum allotment cap per counterparty, which spans from dealers to money funds to government-sponsored entities, on these daily temporary open market operations is currently $5 billion at a fixed rate of 0.03 percent.
Usage of the Fed facility surged before the end of last year as rates for borrowing and lending securities slid and banks shored up balance sheets. The Fed Bank of New York drained $197.8 billion on Dec. 31, the largest amount in a test of its fixed-rate reverse repo facility. The average daily use since it began in September has been $30 billion and $74 billion this year.
Simon Potter, the New York Fed’s markets group chief, said in Dec. 2 speech in New York that the reverse-repo tool will probably play a central role in eventual tightening monetary policy. The Fed has kept the benchmark federal funds rate in a range of zero to 0.25 percent for five years while purchasing billions of dollars of bonds to drive down longer-term rates to encourage spending and hiring. The majority of Fed policy makers predict the first rate increase will occur in 2015.
“We see this as the key policy issue they will be working on going forward,” Sack said in the telephone interview, referring to the Fed’s determination of an appropriate framework for managing short-term interest rates.
Sack, who served as the Federal Reserve System’s Monetary and Financial Markets Analysis section chief in 2003 and 2004, and another former Fed staffer envision the reverse-repo facility providing a new operating framework for monetary policy and not merely a tool to help remove accommodation.
Joseph Gagnon, a senior fellow at the Peterson Institute for International Economics in Washington and a former Fed economist, co-wrote with Sack a paper last month that proposed the Fed use the rates at which it offers overnight reverse repos as its policy instrument. That would allow the Fed to maintain a “substantially elevated” balance sheet and ’’abundant liquidity’’ in the financial system.
The reverse-repo rate, which would ideally match the rate the central bank pays on banks’ excess reserves, would serve as a floor to money-market rates and prevent the gaps that exist between the Fed’s benchmark and other money-market rates, Gagnon and Sack wrote.
While the Fed gained the ability in 2008 to pay interest on cash it holds in the form of excess reserves, currently at a rate of 0.25 percent, that tool has had limited effect in anchoring borrowing costs because only banks are able to earn such interest.
The fed funds effective rate, a volume-weighted average on trades by major brokers published daily by the New York Fed, averaged 0.14 percent since December 2008. While the rate for borrowing and lending Treasuries for one day in the repo market averaged 0.15 percent since November 2009, according to the DTCC GCF Treasury Repo index that has data back through that date.
“By extending the reverse-repo program through next January, the Fed has effectively made it permanent,” Joe Abate, a money-market strategist in New York at primary dealer Barclays Plc wrote in a note to clients on Jan. 31. “Our sense is that the Fed intends to ratchet allotment sizes up steadily all year.”
The Fed last month noted the likelihood that the facility could be ramped up further this year.
“It is expected that, over the coming months, the maximum allotment cap may be increased further,” the New York Fed said in a statement on Jan. 29, the day it extended the facility and lifted the allotment size to $5 billion per counterparty from $3 billion.
Participation in the facility may increase now, in addition to typical high demand at quarter and year end periods, as money-market funds and government-sponsored agency grow more confident to replace repos with primary dealers to those with the Fed, given the program is viewed as more permanent, according to Brian Smedley, an interest-rate strategist in New York at Bank of America Corp., a primary dealer.
The fixed-rate reverse repo facility is open to Fed’s 139 tri-party reverse repo counterparties, which include 94 money-market mutual funds, six government-sponsored entities, 18 banks and the Fed’s 21 primary dealers. The collateral for the transactions has been limited to Treasury debt.
In a reverse repo, the Fed lends securities for a set period, temporarily draining cash from the banking system. At maturity, the securities are returned to the Fed, and the cash to its counterparties.
Fed policy makers last month, as well as cutting the monthly pace of asset purchases by $10 billion to $65 billion, reiterated that the federal funds rate is likely to stay almost at zero until “well past” the time that unemployment falls below 6.5 percent. The jobless rate was 6.7 percent in December, a five-year low.
“The concepts of utilizing the reverse repo rate as a new policy framework could pick up more steam, especially if the Fed wants to stay its course with tapering,” Kenneth Silliman, head of U.S. short-term rates trading at Toronto-Dominion Bank’s TD Securities unit in New York said in a telephone interview on Feb. 3. “Lowering the interest rate on excess reserves, which has clearly become an outlier rate, wouldn’t be a bad way to begin developing it.”
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