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MNI INTERVIEW:Some Volatility Healthy During QT -Fed Economist

MNI (Washington)

Repricing administered rates can bring back some healthy rates volatility, Richmond Fed economist says.

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The Federal Reserve should consider repricing its administered rates as monetary policy tightens and assets run off to allow room for a healthy amount of rates volatility, Richmond Fed economist Huberto Ennis said in an interview.

"In the process of normalization, we might see a little bit more rate volatility, and I’m not sure that we should be so aggressive about reducing that volatility," Ennis said. "We can welcome volatility, instead of intervening in ways that create unintended consequences. The market has to adapt to it and plan for it."

The Fed's overnight reverse repo facility saw an unprecedented surge in demand after the central bank started paying 5 bps interest to prevent yields from going negative, with usage averaging USD1.6 trillion in December. Record injections of reserves into the banking system to fight the Covid-19 pandemic had driven up demand for short-term securities by money market funds.

ON RRP usage is expected to decline as the Fed unwinds its asset purchase program and banks increase rates, creating an opportunity for the Fed to reassess its pricing of the facility, Ennis said.

"Initially the ON RRP facility was thought of as a backstop facility, but now it’s a preferred investment for money market funds," Ennis said. "Once you normalize rates and reserves go down, ON RRP could come back to play a backstop role. I think that would be a good thing."

STANDING REPO FACILITY

With negative rates on repos less of a concern as rates head higher, the Fed could raise the spread between the ON RRP facility rate and interest paid on reserves from the current 10 bps, Ennis said.

Similarly, for the Fed's newly-created standing repo facility, a backstop that can offer funding in exchange for Treasuries in times of stress, a 10-bp spread between interest on reserves and standing repo is "not really leaving much room for volatility," he said.

"It’s important to balance Fed intervention in markets and not have the Fed be the preferred investment vehicle," he said. "We can move those rates so that that’s not the case."

The standing repo facility also offers a safety net for operating with a relatively small level of reserves, allowing room for a faster run-off of Fed assets without ructions in rates markets, Ennis added.

"By looking at the usage of the SRF, you could also assess the level of reserves and how close you are to that minimal level. If you see volume there, that would mean reserves are not so abundant anymore. Eventually you could, by looking at the usage, infer the appropriate minimal level of reserves in the system."