US Fed needs adaptable repo response

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    More flexible. A view shows an eagle sculpture on Federal Reserve building. The recent repo hiccup should serve as a warning: A less flexible market requires a more flexible Fed. (Reuters Photo)
    More flexible. A view shows an eagle sculpture on Federal Reserve building. The recent repo hiccup should serve as a warning: A less flexible market requires a more flexible Fed. (Reuters Photo)

    By Anna Szymanski

    NEW YORK- Bond buying is back. US Federal Reserve Chairman Jay Powell said on Tuesday that the Fed will start adding to its balance sheet again. It’s not officially a return to so-called quantitative easing: Rather, it’s a response to money-market volatility last month.

    The repo market, where banks and other financial players use repurchase agreements to get hold of $2 trillion in cash every day in exchange for collateral like bonds, is usually invisible. It only makes news when something goes wrong – like the collapse of Lehman Brothers in 2008. The recent repo ructions were far less dramatic than that. But they were a sign that the Fed needs to adapt.

    In mid-September, multiple factors caused the US financial system to become cash poor.

    There was a deadline for paying corporate taxes, and payment for recently purchased government bonds was also due. For both those purposes, banks transferred money to the US Treasury. Their spare cash, as measured by the excess reserves held at the Fed above the minimum required, fell to the lowest level since 2011.

    Repo borrowers ultimately needed more cash than lenders were willing to give them at the normal repo rate – around 2 percent. So the rate spiked to 10 percent. This is when the New York Fed, under President John Williams, stepped in.

    It’s essentially injecting cash into the economy. The New York Fed is giving billions of dollars a day to primary dealers – an exclusive club including firms like JPMorgan and Citigroup– in exchange for treasuries and other super-safe bonds. This increases the cash the primary dealers have available to lend.

    They then do repos with other banks, hedge funds, and others who need the cash. Repos are short-term collateralized lending transactions – they come with an interest rate. By adding cash to the financial system each day, the Fed is trying to keep the repo rate down.

    The Fed’s injections were initially a little late and clumsy, but they served to bring the rate down to normal levels. It has continued pumping billions into the market every day since. And it said last week that it will inject at least $75 billion into the overnight repo market daily through early November.

    Large banks probably had excess reserves to lend back in September. But that doesn’t mean lending in the repo market would have been the right business decision.

    After the financial crisis a decade ago, regulators wisely started requiring banks to hold more safe assets like cash and treasuries. This makes every dollar that can be lent out more valuable. And repo transactions are not super profitable. Also, banks have learned that, in a crisis, only cash is cash. So they use internal risk models, not just regulators’ decrees, to determine their appropriate level of cash reserves.
    Didn’t the fed do this all the time before the financial crisis?

    Yes, but the crisis changed everything. Before 2008, the Fed controlled interest rates mostly through open market operations in the form of outright purchases, repos and reverse repos (which are what they sound like – the Fed takes cash and hands over bonds, rather than the other way around). The goal was to ensure that the federal funds rate – the rate at which banks lend to each other overnight – stayed in the Fed’s target range.

    This system worked because the Fed’s balance sheet was small – under $1 trillion. The liability side was largely made up of currency in circulation, with a tiny amount of bank reserves on top. But quantitative easing, or bond buying, after the crisis inflated the balance sheet to some $4.5 trillion. Matching the increase in assets, as well as more currency, was a huge expansion of bank reserves.

    When reserves were scarce, the Fed was able to make them more or less valuable – and alter short-term interest rates – just by controlling their supply. But with reserves so much more abundant after the crisis, the Fed had to change its tool kit. Its main levers became the interest it pays on excess reserves, known imaginatively as IOER, and the rate used in its overnight reverse repo operations. The Fed can adjust the IOER and the reverse repo rate to put a floor under short-term interest rates.

    Powell has been continuing the Fed’s effort to “normalize” – or shrink – its balance sheet to exit the postcrisis quantitative easing era. Whatever purists might wish, it was never going to get back down to precrisis levels, partly because currency in circulation has doubled to $1.8 trillion in the past 10 years. – Reuters