Interesting piece on Barry Ritholz’ Big Picture blog yesterday, Implementing Monetary Policy: Perspective from the Open Market Trading Desk. An excellent follow-up to our last week’s post, Orwellian Monetary Policy.
Recall we noted the structural change in monetary policy and what seems to be an inconsistency where the Fed now injects liquidity into the financial system by paying (printing) interest payments on excess reserves to raise the Fed Funds rate. Prior to the crisis, the Fed would raise the Fed Funds rate by removing reserves or draining liquidity from the banking system.
The Fed also now uses a supplementary tool, the overnight reverse repurchase agreements (ON RRPs) to keep the Fed Funds rate at the target level.
Here are the money quotes:
The primary tool—interest on reserves (IOR)—applies to the reserve balances held by banks in their accounts with the Federal Reserve.3 In principle, the federal funds rate should not fall below IOR, because depository institutions have no incentive to lend federal funds at interest rates below what they could earn simply by leaving the funds in their reserve accounts. However, a number of frictions have caused the effective federal funds rate to print moderately below IOR, leading the Federal Reserve to use a supplementary tool—a facility that offers overnight reverse repurchase agreements (ON RRPs) at a specified offering rate to a wide range of counterparties.4
The ON RRP facility helps to reinforce the floor under market interest rates by providing an outside investment option to a broad group of nonbank market participants that are not eligible to earn IOR.5 We’ve observed that a high volume of actual ON RRP usage has not been necessary to achieve interest rate control. In the first half of 2016, for example, average daily usage of the facility was $63 billion. In principle, even with zero usage, the ON RRP facility can support market rates by ensuring that counterparties demand rates on other investments at least as attractive as the rate offered on the Federal Reserve’s ON RRPs.
The ON RRP facility also serves as a flexible shock absorber that helps to maintain interest rate control when transitory shifts occur in the supply and demand for short-term market instruments. For example, around key month- and quarter-end reporting dates, some financial institutions shrink their balance sheets, a measure that reduces the availability of private money market investments, puts downward pressure on money market rates, and produces higher ON RRP take-up. Last fall, the ON RRP facility also helped to maintain rate control during the implementation of money market fund reform by temporarily absorbing heightened demand for safe, overnight investments by government money market funds. – The Big Picture
In our opinion, monetary policy still a black box as to how/when it ultimately affects the economy.