Fed’s Limited-Time Offer in Money Markets May Be Hard to Cut OffCraig Torres and Christopher Condon
The Federal Reserve is about to take an unprecedented plunge into money markets. It plans to make it a limited-time offer, but the assets are so attractive that it may be forced to extend the life of the deal.
As soon as this year, Fed policy makers will greatly expand a $100 billion-dollar market for overnight loans known as reverse-repurchase agreements. They are designed to suck money out of the financial system so the Fed can raise short-term interest rates. They will also provide money-market funds and banks with safe investments that are now in short supply as financial-market reforms have heightened their need to hold exactly such assets.
The U.S. central bank’s potentially gigantic footprint in money markets poses risks. Establishing a long-term presence could crowd out private borrowers who use the markets for everything from financing inventories to managing seasonal flows of cash.
Fed officials are trying to convince investors that eventually they want to stop using reverse repos. Their arguments don’t seem credible to many, including economists who once worked there.
“It is very fair to say this is going to be a permanent feature of the financial landscape whether they like it or not,” said Roberto Perli, a partner at Cornerstone Macro LLC and former associate director in the Fed Board’s policy strategy unit, referring to the reverse repo facility.
A big, lasting Fed footprint could weaken repo markets by absorbing market share from trading partners such as Wall Street’s primary dealers in government bonds, a list that includes Morgan Stanley, Cantor Fitzgerald & Co. and Nomura Holdings Inc. In a panic, the Fed facility could become a safe haven, leaving other borrowers with little financing.
Laura Rosner, a U.S. economist at BNP Paribas in New York, said the central bank’s caution is understandable: “The Fed would be taking a long-lasting role in short-term financial intermediation. Should it have that role? Right now there is a private market for that.”
Fed Chair Janet Yellen stated her intent to keep the program manageable at her June 17 press conference.
“It is our expectation and plan that fairly quickly after liftoff we will reduce the level” of the reverse repo facility, she said. Minutes of meetings of the policy-making Federal Open Market Committee this year show it is one of the most discussed programs as the Fed plans its exit from unprecedented monetary stimulus.
The Fed’s intended retreat from the program is “going to be a challenge, but I take the Fed at its word,” said Steven Meier, head of cash, currency and fixed income at Boston-based State Street’s money management unit. “It’s not their intention to be the dominant player in the market.”
In an overnight reverse repo, the Fed borrows cash from counterparties -- including dozens of money-market funds such as those managed by BlackRock Inc., Charles Schwab Corp., the Vanguard Group Inc. and State Street Corp. -- and posts securities from its bond portfolio as collateral. The next day, the Fed returns the cash plus interest to the lender and gets the securities back. The transactions are repeated as needed to keep the federal funds rate in the target range.
The need for such transactions arises because the Fed is preparing to raise interest rates after having built up a $4.5 trillion balance sheet through bond purchases intended to stimulate the economy. Those purchases flooded banks with $2.5 trillion more in reserves than they are required to hold.
That cash needs to be pulled out or tied up for the central bank to achieve its goal of increasing short-term interest rates by raising the federal funds rate, the cost of overnight borrowing between banks, from its current range of zero to 0.25 percent.
One way to control that is through the rate of interest paid to banks that keep excess reserves on deposit at the Fed. As long as that rate, currently set at 0.25 percent, is higher than the federal funds rate, banks probably won’t dump their excess cash into the interbank market.
But that facility is available only to banks, not to entities such as money-market mutual funds. They will be seeking returns on their cash in overnight markets, and could be transacting below the Fed’s target rate. The reverse repo facility aims to solve that problem, setting a floor rate for the rest of the market.
The Fed has been running tests since December 2009, and daily transactions average about $113 billion this year.
Demand for the facility “could conceivably be much greater than what we have seen” in recent tests “as regulatory and structural changes in money markets boost demand for safe assets,” according to Simon Potter, head of open-market operations for the FOMC and executive vice president at the New York Fed. He made those comments at an April speech in New York.
That concern is well-founded, said Joseph Gagnon, a senior fellow at the Peterson Institute for International Economics in Washington.
“They are going to find it is more difficult than they think to reduce” the reverse repo facility, said Gagnon, who served in a variety of positions at the Fed board. “There will be a lot of demand for safe investments.”
Contributing to that demand, regulators now require money-market funds to have 10 percent of their assets in cash, Treasury securities or other securities that can convert to cash in one day. That change came after some funds experienced runs during the financial crisis.
What’s more, starting next year, so-called prime funds that invest in corporate debt for institutional shareholders must convert to floating share prices instead of the once dependable $1 per share. That change could also create new demand for stable net-asset-value products that invest solely in government debt.
“There is a shortage of government safe assets in short-term debt markets,” said Joseph Abate, a Barclays Plc money-market strategist.
Treasury bills fell to 11 percent of total Treasury debt outstanding in June, the lowest level in records going back to 1952, according to data from Barclays.
Commercial paper, or short-term IOUs issued by banks and corporations and typically held by money funds, is also about a half-trillion dollars lower on average than in the last expansion.
Former Fed Governor Jeremy Stein said that if the intent of the Dodd-Frank Act and other regulatory reforms was to discourage funding with short-term instruments that are less safe than deposits, then the government can help the cause by supplying more of what investors want to hold.
“I like a world in which either the Treasury provides more short-term bills, or the Fed makes available quite a lot of its own Fed-created repo,” Stein, now an economics professor at Harvard University, said in an interview.
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