Let me say at the outset that I believe the Fed’s Overnight Reverse Repo Facility (“RRP”) will, in time, succeed in sufficiently influencing overnight interest rates and as a result it will be an effective policy tool. This post is about uncertainties surrounding the implementation of the RRP, and potential growing pains that may need to be worked through during the initial months of the Fed’s policy tightening pathway. If given their druthers, I suspect the Fed would prefer any month other than December, when staffing levels are light and huge sums of money are in motion for year-end balance sheet management, to roll out the RRP in prime time. Luckily or unluckily though, the Fed now has their window and they’re clearly inclined to press ahead.
The RRP exists to put a floor under overnight interest rates where the Interest on Excess Reserves (“IOER”) rate could not do so. Only US domestic banks may access the IOER rate, and certain banks (e.g. the Federal Home Loan Banks – “FHLBs”) do not earn interest on excess reserves, and therefore lend their reserves to commercial banks in the much-shrunken Fed Funds market at rates considerably lower than IOER. Additionally, money market funds, who compete with the banks and FHLBs for income-producing assets with very short maturities, can force other critical short-end interest rates substantially lower than IOER without some other mechanism to satisfy their demand for assets. The RRP has the potential to provide money market funds (and by extension, the investing public) limitless risk-free overnight assets at a rate floored by the Fed’s monetary policy. For now, the RRP rate is 5bp, but it’s expected to be hiked to 25bp (while IOER goes up to 50bp) on December 16. Were it that simple, any debate about the effectiveness of RRP as an interest rate floor would end.
However, I would note the uncertainties below. Taken together, I still do not believe they pose a policy transmission problem, just that the remainder of December might be a bit dicey:
I think the questions these uncertainties generate have pretty straightforward answers, and the Fed will make adjustments if it’s not perfect on day 1. They’re also planning ahead, having already announced a $300bn term RRP over year end, which is in addition to the overnight one which will be set on December 16. My point is merely that the program might feel a bit unwieldy at first in jittery markets.