The Fed's "full-allotment overnight reverse repurchase agreement facility" (FRFA) - a mechanism to control short-term rates (see post) - is no longer just an academic exercise. Given how dysfunctional the interbank market has become (see post), using the fed funds target as the only post-QE monetary tool is no longer an option. FRFA allows the Fed to set a floor under the overnight secured lending rate (repo) by offering to borrow funds from a broad array of market participants - not just banks - at a fixed rate. Because this facility is effectively a riskless deposit with the Fed (legally it's a loan to the Fed), there shouldn't be any meaningful private transactions at rates below the FRFA rate - thus the rate floor. This mechanism also prevents the overnight rates from becoming negative - as was the case in some markets in Europe - to make sure that money market funds continue to function.
The Fed has been testing the facility since last September and seems to be happy with the results. The demand for the facility picks up sharply when the FRFA rate is about 4-5 bp below the private market repo rate. That's the discount that investors are willing to accept on their "deposit" rate in order to keep their money with the Fed rather than with a private institution.
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| Source: NY Fed (GCF stands for General Collateral Financing, meaning that any treasuries can be used as collateral as opposed to specific securities) |
Late last year the Fed raised the maximum FRFA bidding amount to $3bn from $1bn, as testing progresses to the next phase. When the program becomes fully operational, these amounts would increase dramatically.
One by one the Federal Reserve officials are preparing the markets for the FRFA implementation. Once QE winds down, the FRFA fixed rate becomes the next monetary policy tool.
1. Simon Potter (last month):
WSJ: - ... Simon Potter, who runs the New York Fed's markets group, gave a big thumbs up the reverse repo program based on what he's seen with the testing.2. Bernanke:
He said in his speech the overnight reverse repos "may strengthen the floor for short-term interest rates and, with it, the Federal Reserve's control of money market rates, by surmounting the competitive and balance sheet frictions seen in money markets and by extending the central bank's payment of interest to a wider universe of relevant counterparties."
CBS: - Looking into the years ahead, Bernanke said the central bank has the tools -- including adjusting the rate on excess bank reserves and so-called reverse repurchase agreements, or repos -- to return to a normal policy stance without resorting to asset sales.3. Dudley:
"It is possible, however, that some specific aspects of the Federal Reserve's operating framework will change,” he said. On the economy, Bernanke noted unemployment remains elevated at 7 percent, and said the number of long-term unemployed Americans “remains unusually high.”
BW: - Dudley said the Fed may decide to extend a program involving so-called reverse repurchase transactions aimed at giving it greater control over short-term borrowing costs.4. Williams:
The new tool, called the fixed-rate, full-allotment overnight reverse repurchase facility, is intended to put a floor under short-term money-market rates. It allows banks, broker-dealers, money-market funds and some government-sponsored enterprises to lend the Fed unlimited amounts of cash overnight at a fixed rate in exchange for borrowing Treasuries in reverse repo transactions.
BW: - Federal Reserve Bank of San Francisco President John Williams said reverse repurchase transactions may be an effective way for the Fed to control interest rates when it starts withdrawing unprecedented stimulus.
“This is potentially a very useful tool,” Williams said to reporters today after a speech in Phoenix. “It allows us to manage short-term interest rates more directly even at the same time that we have a very large balance sheet and lots of excess reserves.”
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