Rpt: ​​MNI EXCLUSIVE: Fed to Hike Reverse Repo, IOER Rates

The Federal Reserve will likely hike the interest rates it pays on both overnight reverse repos and excess bank reserves in the next few months to keep its benchmark fed funds rate trading comfortably above zero as the Treasury releases over a trillion dollars in reserves into the financial system, former Fed officials told MNI.

With repo rates hovering near zero in recent weeks and downward pressure building, sources said the Fed will likely increase both the ON RRP and IOER rate by 3 to 5 bps to keep market rates in line with the central bank's target interest rate range of 0% to 0.25%. Such an adjustment would keep the spread between ON RRP and IOER at 10 bps.

"What they will do is try and figure out how to stuff reserves into ON RRPs," said Stephen Cecchetti, former director of research at the New York Fed, adding the Fed could further boost take up of the reverse repo program by raising per-counterparty limits, now set at USD30 billion. "As long as the Fed increases ON RRP [rate], that could suck some reserves back out" out of the banking system.

Treasury Secretary Janet Yellen caught markets by surprise earlier this month when she announced the Treasury would run down the USD1.6 trillion in cash stockpiled during the pandemic at a faster clip than expected. Treasury said it anticipates reducing the size of the Treasury General Account at the Fed to USD500 billion by June, effectively returning as much as USD1.1 trillion to the financial system as bank reserves.

Fed research shows an additional trillion in reserves can cause the fed funds rate to decline by 8 bps relative to IOER, MNI earlier reported. The effective fed funds rate is currently trading at 8 bps while SOFR, a benchmark repo rate, is at 5 bps after trading as low as 2 bps earlier this month.

DOWNWARD PRESSURE

There will be downward pressure on the "fed funds rate, repo rates, and other short-term money market rates relative to IOER in the near term and likely for some months out," said David Skeie, a former senior economist at the New York Fed.

The Fed has signaled its plans to continue the USD120 billion a month QE program through year-end at the same time that Treasury has cuts bill issuance and begins to draw down its cash balance to comply with a summer debt limit deadline.

The Fed has tweaked IOER several times in recent years and in January 2020 adjusted both IOER and ON RRP rates. The former officials argue that revising the Fed's reverse repo program may be more effective at a time when the fed funds rate has remained firm relative to IOER.

"In an idealized floor system the IOER is the tool that matters," said Christopher Russo, formerly of the New York Fed's open market trading desk. "But in the real world with imperfect markets, the bifurcation of the funds market, and constraints on bank balance sheets, the ON RRP is available to use."

Inducing greater take up of ON RRP "would be a benefit not just for maintaining overnight rates above zero, but also for decreasing the inefficient balance sheet costs that arise for banks that in aggregate have to hold such an abundance of reserves," Skeie said.

AS SOON AS MARCH

"Raising IOER as well as the ONRRP by 5 bps as a technical adjustment at the upcoming March FOMC meeting would have the benefit of not needing to keep the markets guessing about how soon the next slight technical adjustment might be required," he added. "A 5-bp increase of both would benefit communicating that the economy doesn't hinge on an individual basis point or two but rather that simple rounded policy rate adjustments are adequate."

However, some sources said the Fed may decide to wait a bit beyond the March meeting before acting to make the technical changes, wanting to see the effective fed funds rate trading more consistently below its current level.

In addition to raising the ON RRP rate, one source said, the Fed could also raise the rate on its foreign reverse repo pool that serves about 250 foreign central banks and foreign institutions, to broadly match the rates on the two programs.