Wednesday, August 21, 2013

Fed contemplates creating "overnight reverse repo facility"

Today investors focused on the broad support for tapering in the July FOMC minutes, driving treasury yields sharply higher.

10yr treasury yield (source:

There was however another passage in the minutes that wasn't broadly covered in the mass media.
July FOMC minutes: - In support of the Committee’s longer-run planning for improvements in the implementation of monetary policy, the Desk report also included a briefing on the potential for establishing a fixed-rate, full-allotment overnight reverse repurchase agreement facility as an additional tool for managing money market interest rates. The presentation suggested that such a facility would allow the Committee to offer an overnight, risk-free instrument directly to a relatively wide range of market participants, perhaps complementing the payment of interest on excess reserves held by banks and thereby improving the Committee’s ability to keep short-term market rates at levels that it deems appropriate to achieve its macroeconomic objectives.
It's an interesting development because this project could potentially achieve three objectives:

1. The "full-allotment overnight reverse repurchase agreement facility" can provide competition for bank deposits. While deposits of under $250K rely of the FDIC insurance, corporate and institutional depositors remain concerned about bank credit risk because in a bankruptcy depositors become unsecured creditors. By allowing non-banks to participate, the Fed creates a deposit account that is free of counterparty risk (currently the only way to achieve this is by purchasing treasury bills).

2. Instead of just changing the interest paid on bank reserves to manage short-term rate policy (in addition to the fed funds rate), the Fed would now have another monetary tool - adjusting rates paid on these types of broadly held accounts.

3. By accepting broader deposits, the Fed can effectively "soak up" excess liquidity and "sterilize" some of its securities holdings. And by adjusting these rates, the central bank could fine-tune how much liquidity these accounts attract. This reduces the need to sell securities in order to drain liquidity from the system.
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