MNI INTERVIEW: Fed Could Set Standing Repo Facility At 2.50%

By Jean Yung

     WASHINGTON (MNI) - A standing repo facility allowing banks to swap safe

assets for reserves on demand could be priced at a rate equal to the top of the

Federal Reserve's target range, St. Louis Fed economist David Andolfatto said in

an interview.

     This pricing would enable such a facility - now under consideration by the

FOMC -- to function as a ceiling on short-term money market rates, while

remaining low enough to attract usage in the event of a stress scenario,

Andolfatto, who has written in favor of the idea, told MNI.

     Overnight repo rates have mostly posted below the Fed's current upper bound

of 2.50% in 2019, but occasional spikes have contributed to "optics that the Fed

does not have full control over the policy rate," he said. Though he disagrees

with that assessment, "this type of repo facility would aid the Fed in smoothing

out those spikes."

     The central bank could also use the facility to streamline its balance

sheet, Andolfatto argues. Knowing that Treasuries can be swapped for ready cash,

banks may begin to favor holding Treasuries over reserves, resulting in lower

demand for reserves and giving the Fed the option of continuing to reduce the

reserves pool even after its balance sheet reduction program ends in September.

     "In principle, just by the fact that the repo facility is there and stands

ready might be enough to permit the Fed to drain reserves to a more normal

level, toward the minimum amount needed to implement policy in an efficient and

effectively manner," he said.

     --REGULATOR PRESSURE

     Chair Jay Powell indicated this month the FOMC would consider adding a

standing repo facility to its toolkit as one of several possible strategies to

reduce demand for reserves and ensure interest rate control.

     Banks' demand for reserves is far larger than in the post-crisis era,

driven by new regulations on liquidity and orderly resolution. Fed surveys show

reserves demand has risen considerably even in the past year, a large part of

why the Fed will likely keep a larger balance sheet than previously expected.

     Andolfatto argues that the standing repo facility could prompt banks and

regulators to reassess the optimal mix of reserves and safe assets on bank

balance sheets.

     "We hear banks are getting pressured by regulators to favor holding

reserves over Treasuries for resolution purposes due to the fact that Treasuries

are given significant haircuts at the discount window," he said.

     But, "If the standing repo facility is on standby to accept Treasuries as

cash, then regulators should put less pressure on banks to hold reserves and

banks would be more comfortable holding Treasuries knowing that for resolution

purposes they don't need to hold so many reserves."

     --CEILING TOOL

     Other central banks have used similar facilities in so-called corridor

systems to insulate against interest rate shocks at the upper end. In Canada,

for example, the overnight repo rate tracks the central bank's target rate

closely.

     Likewise, Andolfatto's proposed repo facility would support the Fed's

interest rate control. It "guarantees that the Fed will achieve the targeted

rate. It would do so automatically because if short-term funding need starts to

rise near target, meaning an increase in demand for reserves, the ceiling

facility stands there to spit out reserves on demand."

     If priced near the Fed's target range, the facility might be viewed as

enlarging the Fed's footprint in the market. But "it's less consequential what

happens to the size of the balance sheet because the balance sheet will have to

adjust to whatever size needed to achieve the target rate," Andolfatto said.

     With the FOMC having already decided to keep the overall balance sheet size

steady after September, the facility would help officials estimate the most

"effective and efficient" level of reserves needed without risking interest rate

volatility, Andolfatto said.

--MNI London Bureau; +44 203 865 3829; email: jason.webb@marketnews.com

[TOPICS: MMUFE$,M$U$$$]