MNI EXCLUSIVE: Fed Foreign Repo Boost Could Drain Reserves

The Federal Reserve could explore offering higher returns on its USD190 billion foreign repo pool next year, as it seeks ways to mitigate a surge in reserves threatening distortions in overnight rates, former Fed officials told MNI.

"It seems like it would be a consideration to take the rate up and leave it there for some time," said David Skeie, a former senior economist at the New York Fed.

Bank system reserves rocketed in March and April before settling at around USD3.1 trillion, more than double pre-pandemic levels. But with the Fed's asset purchase program to continue at a minimum of USD120 billion per month for some time and a potential Covid relief bill in Congress drawing down on the Treasury's cash balance, analysts predict reserves could push up to USD5 trillion by mid-2021.

The substantial growth in reserves could push front-end rates downward, and if unabated could cause the fed funds rate to trade in negative territory outside the central bank's target range between 0% and 0.25%, the former officials said.

RESERVES MANAGEMENT

Tools such as raising IOER and overnight reverse repo (ON RRP) rate can put a floor under benchmark rates, and the Fed could adjust the ON RRP facility to reduce the quantity of reserves held by the banking system to relieve pressure on bank balance sheets, New York Fed's market chief Lorie Logan said in a speech this month.

Tweaking the foreign repo pool, where about 250 central banks and other institutions can invest cash with the New York Fed at a rate near ON RRP and receive securities held in the Fed's securities portfolio, "would definitely be in the mix" of other tools considered, said Steven Friedman, a former vice president at the New York Fed. The ON RRP rate is currently set at zero.

By tweaking secondary rates such as this one, "The Fed is flagging the possibility that it might consider taking steps to remove reserves temporarily from the system," said Friedman, who is now senior macroeconomist at MacKay Shields.

Adjusting rates at the foreign repo pool would boost the Fed's liabilities and offset several hundreds of billions in reserves, the former officials said.

Usage of the foreign repo pool has dipped to roughly USD190 billion from a 2020 peak of USD287 billion in April as some foreign central banks sharply reduced their overnight deposits, preferring slightly higher prevailing money-market rates. But the bulk of the cash parked at the New York Fed is from Japan which has remained steady for some time at roughly USD130 billion.

HOT FLOWS

One option for the Fed is to revert to a foreign repo pool rate that closely tracks SOFR, the scheme in place before September 2019 repo market ructions prompted a change in the program, the former officials said.

The foreign repo pool traditionally reflected foreign central banks' preferences to maintain robust dollar liquidity buffers, but in 2019 it grew by nearly USD100 billion, a magnet for hot money offsetting reserves. That swell is widely seen as contributor to the September 2019 episode of market volatility.

Thus in December 2019, the program's rate was lowered from closely tracking SOFR to one "generally equivalent to the overnight reverse repo rate," minutes said.

"Based on prior experience, particularly 2019, the Fed would not want the foreign pool to become too large over time," Skeie said. "The lesson that we learned the last time the rate was set near SOFR is that it can add to volatility over time."

"It's not a high bar to change the rate, but perhaps it's a medium bar," Skeie added.

"The foreign repo pool may be a partial solution," said Nathan Sheets, a former top Fed and Treasury official, now chief economist at PGIM Fixed Income. "But the situation may need broader solutions," something for Treasury secretary nominee Janet Yellen to hash out with Fed chief Jay Powell in coming months, he said.