What happened
- Monday September 16th was corporate tax day in the US, and, as always, there was a big move of cash (around $100 billion) into Treasury’s General Account at the Fed, with a commensurate drain in reserves from the banking system and also large (around $30 billion) outflows from money funds;
- Simultaneously, $54 billion in Treasury securities settled, further boosting the Treasury’s account at the Fed (draining reserves further) and increasing the amount of securities in private hands that needed to be financed. All this came against the backdrop of the Fed’s gradually declining balance sheet.;
- This combination of pressure on bank liquidity, a reduction in money fund cash to be invested in reverse repos, and an increase in securities needing to be financed in the repo market translated into a massive spike in repo rates. By the end of the day Monday repo rates, which have been running a bit over 2 percent, jumped to as high as 5 percent;
- On Tuesday the Fed started injecting funds into the market by conducting overnight repo operations.
An explanation
David Beckworth argues that the Fed unintentionally stumbled from its floor operating system of the past decade back into a corridor operating system, the framework it intentionally left in late 2008. In particular:
- Before 2008 the Fed kept minimal reserves and banks traded for them on the interbank market. The Fed would conduct open market operations to adjust the supply of bank reserves so that a particular interest rate target was hit;
- After 2008 the Fed switched to a floor system so that it could adjust its balance sheet independently of the stance of monetary policy.
The Fed reduced bank reserves via the shrinking of its balance sheet from 2017 to 2019. The goal was to keep the banking system on the flat part of the reserve demand curve (above graph), but with the lowest level of reserves possible. No one knew for sure where that would be, but if it were passed it would be made evident by overnight interest rates rising up. That is exactly what happened the week of September 16.
The Repo Man Cometh
By: David Beckworth – George Mason University
Does the floor system work?
What I’m leading up to is the conclusion that we shouldn’t characterize the problem here as a “scarce reserves,” particularly as some seem to think that implies the Fed needs to buy more assets. The key problem is that the Fed is trying to manage overnight markets by working from the banking sector, through the stock of reserves. Apparently, that just won’t work in the American context, because market frictions are too severe. In particular, these frictions segment banks from the rest of the financial sector in various ways. The appropriate type of daily intervention for the Fed is in the repo market, which is more broadly-based. If $1.5 trillion in reserve balances isn’t enough to make a floor system work, without intervention through either a reverse-repo or repo facility, then that’s a bad floor system.
The Fed’s Failed Experiment
By: Stephen Williamson – Federal Reserve Bank of Saint Louis
Concerns about the future
What’s harder to understand is how money markets will respond to future shocks. As the experience of the past couple weeks has shown, the simple single-bank model no longer works. Reserves are siloed in the flush banks, so the financial system is acting more like it has $1.3 billion in excess reserves than the actual $1.3 trillion. The design of regulation has disrupted some of the system’s most basic functions. The people who oversee it all should be far from sanguine about what the repercussions might be.
Why I’m Worried About the Repo Market
By: Narayana Kocherlakota – University of Rochester
