July 22, 2014, 4:24 PM ET
Fed Worries About Effects of Its New Interest Rate Tool on Markets
By Michael S. Derby
When the Federal Reserve started tests late last year of its so-called reverse repo facility, some officials hoped it would play a starring role in the campaign to raise interest rates when the time comes.
But now the Fed thinks the new tool will play no more than a “useful supporting role,” largely because of rising concerns about its potential effects on the financial system, according to the meeting minutes of the Fed’s June policy meeting and recent comments by Fed officials (who spoke before the week-long blackout period preceding their next meeting July 29-30).
“More and more people are expressing reservations” about the reverse-repurchase agreement facility, said Philadelphia Fed President Charles Plosser in an interview. As the program is currently designed, “there’s a lot of things that might happen to the plumbing of the money markets, and people have gotten…concerned that there’s a lot we don’t know” about how this will all work when put to the test, he said.
Together, the minutes and officials’ remarks shed light on the Fed’s continuing internal debate over how to raise short-term interest rates from near zero, where they have been since late 2008. Officials are still weighing which tools to use and in what combination. The discussions are prompted by worries their traditional main lever for influencing borrowing costs, the federal funds rate, will be less effective than in the past.
The officials agreed at the June meeting that the fed funds rate, an overnight rate on loans between banks, “should continue to play a role” while a newer rate the Fed pays banks on the reserves they park at the bank “should play a central role,” the minutes said. And while the reverse repos would be used as well, officials did not expect them to become a permanent part of their long-run operations.
Through the reverse repos, the Fed lends Treasury bonds it owns for a day in exchange for cash from eligible banks and other financial firms, paying the participants interest on the transaction. Proponents of the tool believed this interest rate could serve as a floor for all short-term rates in the economy.
Fed officials have highlighted two main concerns about the program. First, some worry that in times of financial turmoil market participants might pull their cash out of private markets and move it to the Fed’s repo facility, creating a de facto bank run.
“The broad concern is whether we want to facilitate what could be a period of financial stress by providing in any sense an extremely large or unlimited refuge [for investors], and whether that would tend to exacerbate a financially stressful situation,” Atlanta Fed President Dennis Lockhart told reporters recently.
The second concern cited in the minutes was that the reverse repos, even in a testing phase, could make the central bank a too large presence in the markets “and reshape the financial industry in ways that were difficult to anticipate.”
A recent report from Fitch Ratings said the Fed had become the largest single provider of borrowable Treasury bonds in the broader repo market, where banks go to borrow and lend bonds and invest cash on a very short-term basis.
Fitch observed the Fed was displacing private financial firms that had been lending Treasury bonds. That alarms officials who would rather to see a reduced central bank role in private markets after years of aggressive post-crisis interventions.
Fed officials at the June meeting discussed ways to design the repo program to address the concerns, such as by limiting its usage overall or the parties eligible to participate, the minutes said.
St. Louis Fed President James Bullard told reporters last week that however the Fed wishes to characterize it, the reverse repo facility would still be setting the floor or baseline short-term interest rate in the U.S.
Moreover, the repos have the potential to reach a much broader range of firms because money funds and investment banks are eligible to participate. In contrast, the interest paid on excess reserves only goes to deposit-taking banks, which have become a relatively small part of the overall financial system, he said. “I would think the [reverse repo rate] was the most important rate” for Fed policy, given who would be affected by it, Mr. Bullard said.
But now the Fed thinks the new tool will play no more than a “useful supporting role,” largely because of rising concerns about its potential effects on the financial system, according to the meeting minutes of the Fed’s June policy meeting and recent comments by Fed officials (who spoke before the week-long blackout period preceding their next meeting July 29-30).
“More and more people are expressing reservations” about the reverse-repurchase agreement facility, said Philadelphia Fed President Charles Plosser in an interview. As the program is currently designed, “there’s a lot of things that might happen to the plumbing of the money markets, and people have gotten…concerned that there’s a lot we don’t know” about how this will all work when put to the test, he said.
Together, the minutes and officials’ remarks shed light on the Fed’s continuing internal debate over how to raise short-term interest rates from near zero, where they have been since late 2008. Officials are still weighing which tools to use and in what combination. The discussions are prompted by worries their traditional main lever for influencing borrowing costs, the federal funds rate, will be less effective than in the past.
The officials agreed at the June meeting that the fed funds rate, an overnight rate on loans between banks, “should continue to play a role” while a newer rate the Fed pays banks on the reserves they park at the bank “should play a central role,” the minutes said. And while the reverse repos would be used as well, officials did not expect them to become a permanent part of their long-run operations.
Through the reverse repos, the Fed lends Treasury bonds it owns for a day in exchange for cash from eligible banks and other financial firms, paying the participants interest on the transaction. Proponents of the tool believed this interest rate could serve as a floor for all short-term rates in the economy.
Fed officials have highlighted two main concerns about the program. First, some worry that in times of financial turmoil market participants might pull their cash out of private markets and move it to the Fed’s repo facility, creating a de facto bank run.
“The broad concern is whether we want to facilitate what could be a period of financial stress by providing in any sense an extremely large or unlimited refuge [for investors], and whether that would tend to exacerbate a financially stressful situation,” Atlanta Fed President Dennis Lockhart told reporters recently.
The second concern cited in the minutes was that the reverse repos, even in a testing phase, could make the central bank a too large presence in the markets “and reshape the financial industry in ways that were difficult to anticipate.”
A recent report from Fitch Ratings said the Fed had become the largest single provider of borrowable Treasury bonds in the broader repo market, where banks go to borrow and lend bonds and invest cash on a very short-term basis.
Fitch observed the Fed was displacing private financial firms that had been lending Treasury bonds. That alarms officials who would rather to see a reduced central bank role in private markets after years of aggressive post-crisis interventions.
Fed officials at the June meeting discussed ways to design the repo program to address the concerns, such as by limiting its usage overall or the parties eligible to participate, the minutes said.
St. Louis Fed President James Bullard told reporters last week that however the Fed wishes to characterize it, the reverse repo facility would still be setting the floor or baseline short-term interest rate in the U.S.
Moreover, the repos have the potential to reach a much broader range of firms because money funds and investment banks are eligible to participate. In contrast, the interest paid on excess reserves only goes to deposit-taking banks, which have become a relatively small part of the overall financial system, he said. “I would think the [reverse repo rate] was the most important rate” for Fed policy, given who would be affected by it, Mr. Bullard said.
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