Forward guidance: Why did the staff brief the FOMC on two near-term balance sheet issues?

From: Bill Nelson <[email protected]>

Sent: Thursday, December 5, 2024 9:24 AM

Subject: Why did the staff brief the FOMC on two near-term balance sheet issues?

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The minutes of the November FOMC meeting indicated that staff briefed the Committee on two issues concerning near-term balance sheet management.? First, the staff discussed the possibility of lowering the interest rate the Fed pays at the overnight reverse repurchase agreement (ON RRP) facility by 5 basis points.? Second, the staff reviewed what would happen to reserve balances (deposits of commercial banks at Federal Reserve banks) during and after the next debt ceiling debacle.? Considering both topics now is prudent risk management in advance of the eventual end of QT.

The ON RRP facility is a standing facility where primarily money market mutual funds and Federal Home Loan Banks conduct reverse repos with the New York Fed at the ON RRP rate.? In the reverse repos, the counterparty provides the Fed cash and the Fed provides the counterparty a Treasury security.? The next day the operation is reversed, with the Fed paying back the cash plus interest and the counterparty provides back the Treasury security.? The interest rate the Fed pays on the RRP is currently equal to 4.55 percent, 5 basis points above the lower limit of the FOMC’s target range for the fed funds rate.? The facility effectively provides money funds and FHLBs interest-bearing deposits, something Congress did not authorize the Fed to do.? The transactions are conducted under the Fed’s authority to conduct open market operations (Section 14 of the Federal Reserve Act); it can conduct such operations with anybody.

The facility was created in 2013 as a tool to ensure that the Fed could lift the effective federal funds rate, the interest rate the Fed targets to conduct monetary policy, above zero when it decided it was appropriate to do so. The federal funds rate is the market rate at which banks, or banks and GSEs, lend to each other, usually overnight, on an unsecured basis.? The primary tool the Fed uses to control the fed funds rate is the interest on reserve balances (IORB) rate, the interest rate the Fed pays banks on their deposits.? The Fed was concerned that when it increased the IORB rate the fed funds rate would not increase in tandem; the ON RRP facility broadened the set of counterparties significantly.? Raising the ON RRP rate at the same time was intended to backstop the increase in the IORB rate (it worked).? For more information on the ON RRP facility see here and here.? For more information on how the Fed implements monetary policy see here.

The facility was supposed to be temporary, indeed several governors including then governor Powell expressed significant misgivings about the facility when it was created, in part because they were reluctant to expand the Fed’s set of counterparties, especially to include money funds which had contributed to the Global Financial Crisis.?

At the start, and for much of its operation, the ON RRP rate has been set at the bottom of the FOMC’s target range for the fed funds rate.? A low rate was intended to ensure that the facility would only be used when interest rates fell too far below the IORB rate and so that use of the facility would decline to zero when the situation normalized.? However, in June 2021, when repo rates fell to 1 basis point and the fed funds rate to 6 basis points, the Fed raised the ON RRP rate 5 bp above the bottom of the range, which was then zero.

The minutes provide no information on why the staff at the November meeting discussed the possibility of lowering the ON RRP rate by 5 basis points other than stating the obvious fact that doing so would reduce it to the lower end of the range.? In a later section, the minutes state that some meeting participants (Board members and Reserve Bank Presidents) wanted the Committee to consider such an adjustment.? Again, the only reason given was that doing so would align the rate with the bottom of the range.?

Clearly the Committee had requested the briefing and is considering such an adjustment, but why?*? Afterall, the Committee could have made such an adjustment at any time, including when the relatively high yield on the facility was contributing to bank stress in spring 2023 by sucking deposits out of the banking sector (see here).? Two possibilities come to mind.

First, the Fed may be considering lowering the rate so that use of the facility declines to zero and the facility can be mothballed.? The ON RRP facility was supposed to be temporary, is borderline against the will of Congress, and further entangles the Fed with the financial system.? Moreover, if the facility use is zero rather than positive (currently $160 billion), reserve balances will be higher, which will allow QT to continue for longer and the Fed to get smaller.? When the FOMC officially adopted its current implementation framework, Chair Powell said that he would experience “buyer’s regret” if the framework required more than $1 trillion in reserve balances.? Reserve balances are currently $3.2 trillion.

Similarly, lowering the ON RRP rate could help reduce the foreign reverse repo pool, which has grown to $400 billion from its pre-GFC level of about $30 billion.? The Fed provides foreign central banks and other international and foreign official institutions a standing facility where they can invest funds overnight with the Fed in the form of reverse repos, earning the ON RRP rate.? If the Fed lowers the rate, foreign institutions will invest less in the pool, allowing the Fed to get smaller still.

Second, and this is entirely speculative, perhaps the Fed is concerned about fed funds transactions dwindling to near zero.? The market now consists of FHLBs lending to the U.S. branches of foreign banks.? FHLBs have accounts at the Fed but do not earn interest.? But they can invest in the ON RRP facility and earn the ON RRP rate.? Branches can borrow from the FHLBs and leave the funds in their accounts at the Fed, earning the IORB rate, currently 4.65 percent.**? The fed funds rate is currently 4.58 percent, providing FHLBs a bit more than they would get at ON RRP and costing branches a bit less than they earn when they deposit the funds at the Fed.

But the FHLBs don’t have to invest in the ON RRP facility, they can also invest in the repo market.? Repo rates have been edging up relative to the ON RRP rate, and have recently been running at around 4.64 percent, just a basis point below the IORB rate and 6 basis points above the fed funds rate.? If the FHLBs decide to stop investing in fed funds and instead invest in reverse repo, there would be essentially no fed funds transactions.? Not only is the fed funds rate the FOMC’s target rate, it is also the basis for OIS swaps and other interest rate derivative contracts, so it is a big problem if there is no fed funds rate.? By lowering the ON RRP rate a bit, repo rates will move down, keeping fed funds relatively attractive.

Of course, the Fed would make more rapid progress toward both of these objectives if it increased the IORB rate as well as decreasing the ON RRP rate.? What matters is the spread between the two rates.? For most of the ON RRP facility’s operation, including long stretches with zero use, the IORB rate was at the top of the FOMC’s 25-basis-point-wide target range and the ON RRP rate at the bottom.

The second staff briefing discussed the swing in the Treasury General Account (TGA, a deposit account at FRBNY) that will occur around the next debt ceiling debacle. Such swings could derail QT if the Fed doesn’t take action to smooth out the consequences for reserve balances.? Before the GFC, the TGA was held to about $5 billion, now it is about $800 billion.? The higher balance is purportedly maintained in case there is an emergency that prevents the Treasury from conducting auctions, but it also helps the Treasury manage the situations when the debt hits the ceiling.?

According to this week’s Money Market Observer here, debt ceiling constraints may force the Treasury to draw down its cash balance in the first half of 2025, with legislative relief not arriving until the late spring or summer.? The decline in the TGA will raise reserve balances offsetting the effect of QT on reserves.? The trouble will come when the debacle is concluded, and the Treasury refills the TGA.? At that point, reserve balances will decline rapidly.? Because reserve balances are likely in the range of banks’ current structural demand, the decline will most likely cause significant pressure in money markets.

To avoid that outcome, the Fed will, I hope, engage in offsetting temporary repo operations to smooth out the decline.? If so, they will avoid making the mistake they made in September 2019:? The Fed took no advance action when the conjunction of corporate tax payments and Treasury coupon security settlements predictably led to both a severe supply-demand imbalance in repo markets and a sharp drop in reserve balances.? For more information on the September 2019 repo madness see here.

As always, please feel free to share this email with anyone who might be interested.? I’d be happy to add anyone to this free email distribution list, just email me and ask.

Bill

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*I am going to spend my retirement comparing the transcripts of meetings as they are released with a 5-year lag to the minutes to see how faithful a record of the discussion the FOMC Secretary has been providing.? Sad, I know.

**U.S. branches of FBO are the fed funds borrowers rather than U.S. commercial banks because of the whacky way the deposit insurance premiums are calculated.? The premiums are based on total bank liabilities rather than insured deposits, so fed funds borrowed (a liability) add to the insurance premium. Branches do not have insured deposits and so do not pay for deposit insurance.

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Bill Nelson | Chief Economist | Bank Policy Institute | 1.703.340.4542

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