Lender of first resort

| January 24, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Fed efforts to flood the market with liquidity since September have pushed most key money market rates toward the lower end of the target range for federal funds. Some analysts and investors have called for a hike in interest on excess reserves, or IOER, to drive up the funds rate along with repo and other money market rates.  But such a move at the upcoming January Fed meeting would be premature and ill-considered.

Money market rate landscape

Before the September repo market debacle, the Fed took a relatively simple approach to steering the money markets. The Fed established a 25 bp target range for the federal funds rate and then moved IOER to try to keep the effective funds rate inside of the range.

The broad framework for the Fed’s operating regime in a world with IOER is supposed to be a corridor system.  The funds rate trades within a range, and the Fed can move the entire range. The IOER rate should be the floor while the discount rate would be the ceiling.  In each case, the Fed stands as the lender or taker of last resort for reserves.  If a bank needs reserves, then, in theory, they should go to the discount window, which, in theory, serves as a cap on how high the funds rate can spike. This abstracts from frictions, such as the stigma that banks place on having to go to the window. Conversely, if a bank has excess reserves and is unable to dispose of them at a reasonable price in the fed funds market, then the bank can deposit them at the Fed and earn IOER.  For the Fed to be the lender of last resort, then, the discount rate should be at or above the top of the fed funds target range so banks would not go to the Fed unless they had already failed to get funds in the market.  The IOER rate should be at or near the bottom of the target range to encourage banks to sort things out on their own and only go to the Fed with excess reserves when they have no better options.

In general, this concept that the Fed should always be the last resort is a centuries-old concept going back at least to Bagehot’s Dictum (1873).  It was deployed to great effect during the financial crisis.  The Fed constructed a variety of programs to backstop various markets that were at risk. The backstops included the PDCF, the AMLF and the TALF, all of which included terms that would only elicit take-up when borrowing rates were well above normal.  Thus, these programs were used only when needed and became unnecessary as soon as the underlying markets calmed down.

However, once the Fed hit the zero bound in 2008, the corridor framework laid out above became garbled.  Policymakers were afraid that a true zero rate would destroy the money market complex and create instability in the financial system, so when the funds rate target was taken to the effective zero bound, the FOMC implemented a 0.00% to 0.25% range for the funds rate.  In addition, the Fed flipped IOER from the bottom of the range to the top since a zero IOER rate might have pushed banks to deploy their funds elsewhere.  More importantly, once the Fed began to conduct QE in an effort to lower long-term interest rates and more generally boost asset prices, the Fed relied on maintaining the IOER rate at the top of the target range to encourage banks to keep their excess liquidity on deposit at the Fed. Hawks worried that the excess liquidity could eventually lead to an explosion in lending and inflation, a fear that ultimately proved ill-founded given how restrictive the financial regulatory environment became.  In essence, the Fed used QE to inflate asset prices but sterilized the liquidity provision by sucking in the bulk of the banking system’s excess reserves with an IOER rate that was higher than most alternatives available to banks.

IOER within the target range

Financial market participants spent a number of years growing accustomed to a money market complex where the IOER rate was among the highest available to banks, making the Fed the option of first resort.  However, once the Fed began to hike the fed funds target rate and to reduce the size of the balance sheet, the FOMC also began to normalize the IOER rate.  Beginning in June 2018, the Fed lowered the IOER within the funds rate target range four times by five bp each.  The last of the four moves was taken with the September 2019 rate cut, at which time the IOER rate moved to only 5 bp above the lower bound of the 25 bp funds rate target range.

The Fed undoubtedly took the latest tweak partially to address repo rates spiking in mid-September, a lower IOER rate might help to reduce funding costs at the margin.  Of course, the Fed subsequently decided to implement a heavy array of overnight and term RP operations to tamp down repo market pressures and, at the same time, to reverse course and grow the balance sheet again through Treasury bill purchases.

The result of all of this massive liquidity provision over the last few months is, not surprisingly, that money market rates have drifted lower.  Prior to the mid-September blowup, the effective funds rate had been trading near the middle of the target range, with repo rates generally trading higher than that.  However, with the system flooded with extra liquidity—still close to $200 billion in RP outstanding from the Fed while about $200 billion in Treasury bill purchases have boosted excess reserves by a commensurate amount—the funds rate has spent the last three months or so trading at 1.54% or 1.55%, only 5 bp above the bottom end of the target range – and in line with the IOER rate.  In addition, the overnight repo rate has generally been trading just a few basis points above the effective fed funds rate, a narrower spread than was the norm going back to, say, last summer.

Repo market lender of first resort

The conventional Bagehot prescription when the New York Fed constructed the term and overnight repo operations would have been to offer repo financing at a rate modestly higher than where the Fed wanted the market to trade.  The logic would be that the Fed would stand as a backstop but, ideally, once the September 16 crisis footing faded, the repo market would clear on its own, with the Fed standing behind it to make sure that rates were not “too high.”

Instead, the New York Fed jumped in with both feet and offered liquidity at rates that were, if anything, below the market rate that would have prevailed under normal conditions.  Even after the immediate liquidity crunch was over, the take-up on Fed operations remained large, and the explanation was that primary dealers did not need the cash but were happy to take it at rates well below where the market was trading.  This is a classic example of the Fed becoming a lender of first resort.

From the perspective of leveraged players, who need to borrow in the repo market to fund their positions, the Fed’s provision of liquidity at a generous price is wonderful.  However, for money funds, who are on the other side of that equation and are lenders in the RP market, the Fed is costing them money.  In fact, money funds have begun to complain vehemently, and are agitating for a 5 bp hike in the IOER rate at the upcoming FOMC meeting to fix this problem.

Time to step back

However, a boost to the IOER rate now would be premature.  What the Fed really needs to do, and sooner rather than later, is begin to wean the market off of its extensive RP operations.  The Fed has been incredibly cautious, too cautious, but is finally beginning to do so.  The maximum size for the 14-day term operations will drop from $35 billion to $30 billion at the beginning of February, which will ultimately reduce the ceiling of term money available from $140 billion to $120 billion.

It seems that the Fed has been deathly afraid of pulling back too much too soon, which is why it has barely reduced funding even after the repo market survived the turn of the year without a hitch.  The easy way for the Fed to step away from the repo market without causing disruption is to get back to the Bagehot prescription and price itself out of a starring role.  The New York Fed has presumably finally begun to do so over the past week.  Both overnight and term operations had been consistently offered at 1.55%.  The 14-day term operation on Tuesday was offered at 1.56%, and the Thursday term operation was offered at 1.57%.  Not surprisingly, Thursday’s offering was somewhat undersubscribed with only $30 billion take-up.

Rather than using a sledgehammer approach  and raising IOER, the Fed should be able to quietly and smoothly get repo rates higher by continuing to slowly push its offering rates higher for term RP until it has once again made itself the lender of last resort, as it should be.  Once the Fed is no longer distorting the repo market with cheap excess funding, the prevailing market repo rate should creep higher and the fed funds rate to inch up, at least slightly, as well.

Managing the money markets this way would minimize the Fed’s footprint as well as giving it insight into the health of the money markets by letting them operate on their own.  The next step in this process would be to get serious about determining how much more to grow the balance sheet (the topic of last week’s piece).

In contrast, if the Fed takes the quick fix and raises the IOER rate by 5 bp as many market participants expect, it will certainly succeed in pushing the effective funds rate and other rates higher within the range, but it will have done so by once again short-circuiting the market’s price-clearing process.  At a minimum, the Fed should work the magnitude of its repo operations down to a less significant size before considering any changes to IOER.  If we fast forward three months and the RP operations have dwindled to nearly zero and money market rates are still viewed as too low, then the Fed could tweak the IOER rate higher.

Similarly, the Fed should wait to tweak the IOER rate until after it has reached what it perceives to be an equilibrium in the size of its balance sheet.  Currently, the Fed is buying Treasury bills to grow excess reserves because it believes that the financial system needs a bigger stock of excess reserves to operate properly and efficiently.  Presumably, adding excess reserves into the financial system would, all else equal, push the funds rate lower.  An Economics 101 treatment of the reserves market would say that if we increase supply, then the price has to fall to reach a new equilibrium, which means that the Fed’s infusion of excess reserves should be pushing the effective funds rate lower.  Indeed, the fact that the funds rate has essentially traded at its floor of IOER since the end of October would suggest that the system was already well-supplied with excess reserves at least a month or two ago.  One could go a step further and say that the underlying problem causing the September money market blowup had nothing to do with the standing level of excess reserves and was entirely due to a financial system that was rendered totally inflexible by an overly stringent regulatory regime, an argument suggested by a number of bank CEOs last fall.

In any case, at a minimum, it makes no sense for the Fed to be adding excess reserves with one hand and simultaneously raising the IOER rate with the other, directly working against itself.  Either the financial system is short of reserves, in which case the Fed needs to be adding liquidity, or money market rates are too low, in which case liquidity needs to be drained.  Fixing the problem by moving an administered rate to force a favored outcome while ignoring the underlying market forces is a recipe for trouble.  Raising the IOER rate at the same time that massive liquidity is being added to both the RP market and excess reserves is downright contradictory.

john.killian@santander.us 1 (646) 776-7714

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