The Federal Reserve will probably borrow “several hundred billion” dollars from money-market mutual funds and others to anchor the federal funds rate when it begins tightening policy, according to St. Louis Fed President James Bullard.
“I don’t think it would have to be that large of a program. Possibly several hundred billion would be enough,” Bullard said, referring to the Fed’s overnight reverse repurchase facility, which it has been testing since September.
“If that didn’t work, the committee could revisit that and increase the size of the program if we thought that was necessary,” Bullard said in an interview yesterday with Kathleen Hays on Bloomberg Radio in Jackson Hole, Wyoming.
The central bank has been testing overnight reverse repos with a limited set of counterparties, mostly money funds, as a tool to set a floor under short-term interest rates when it begins guiding those rates higher, an event Fed officials forecast to occur in 2015.
So far, it has been effective: a key measure of repo market rates calculated by the Depository Trust and Clearing Corporation hasn’t traded below the Fed’s overnight reverse repo rate since Feb. 26, when the New York Fed increased it to 0.05 percent.
In an overnight reverse repo, the Fed borrows cash from counterparties using securities as collateral. The next day, it returns the cash plus interest to the lender and gets the securities back. The central bank has borrowed an average daily amount of $128.1 billion through reverse repos this month.
Members of the Federal Open Market Committee, of which Bullard is a non-voting member this year, “generally agreed” that the overnight reverse repo facility “should be only as large as needed for effective monetary policy implementation and should be phased out when it is no longer needed for that purpose,” according to the minutes of their July meeting.
“Many” also said that “minimal or no reliance” on reverse repos “might result in insufficient control of money market rates at liftoff, which could cause confusion about the likely path of monetary policy or raise questions about the Committee’s ability to implement policy effectively.”
The Fed’s need for a tool to influence repo rates directly arose after almost six years of bond buying to stimulate faster economic growth flooded the banking system with $2.79 trillion of excess reserves. Banks no longer need to borrow reserves in the once-vibrant fed funds market, so the fed funds rate no longer represents the true cost of overnight credit.
The fed funds market is “a mere shadow of its former self, but I think we can maintain some of the focus on the federal funds rate on the grounds that that’s the usual rate that we’ve used to communicate to people,” Bullard said.
In order to raise bank borrowing costs and ensure that the fed funds rate doesn’t trade below the FOMC’s target range when it begins tightening policy, the Fed will have to absorb cash from money funds that would otherwise be lent to banks through repos.
“If not enough of that money sloshing around the system is absorbed through the reverse repo facility, then federal home loan banks and money-market funds will still lend to the banks below the reverse repo rate,” said Aneta Markowska, chief U.S. economist at Societe Generale SA in New York.
Officials plan to use the rate of interest the Fed pays on excess reserves deposited at the central bank as the “primary tool used to move the federal funds rate into its target range” while “temporary use” of the overnight reverse repo facility will be employed to “help set a firmer floor,” according to the July FOMC meeting minutes.
“If we can move those three rates in tandem, then I think it will be pretty clear signaling to markets as to where the Fed stands and where short-term interest rates stand,” Bullard said. “We’ve never done this before, so we don’t know exactly how it will work, but I do think that we are in pretty good shape.”
There is still disagreement among FOMC members over how much borrowing the Fed will have to do through reverse repos in order to make sure the fed funds rate moves up when the central bank wants to start tightening credit conditions.
“We may not need the reverse repo facility at all, because if we raise interest rates and the funds rate goes up with it, why would we need to introduce other dimensions?” said Philadelphia Fed President Charles Plosser in a Bloomberg Radio interview with Kathleen Hays in Jackson Hole, Wyoming.
“I think it’s presumptive to say that we will” need to utilize the reverse repo facility, “because I don’t think we know whether we will or not,” Plosser said. “I think many members are worried about the reverse repo program becoming too big an intervention into money markets, and to the plumbing of our money-market system. We want to be cautious about creating a facility that we can’t get ourselves out of.”