MNI INTERVIEW: Fed Needs Limit On Reverse Repo - McAndrews

The Federal Reserve needs to put a growth limit on the overnight reverse-repo facility as it would remove the destabilizing fear that a run into it is a possibility, James McAndrews, former head of research at the Federal Reserve Bank of New York, told MNI.

"This concern by market participants that the RRP could be a vehicle into which people run does pose a risk to the economy," he said in an interview. "And there's a very straightforward solution to damp down that concern, which is to implement a growth limit."

While there is a per-participant cap of USD160 billion and an absolute limit to the size of the facility now that the Fed enacted several years ago, that number is so large given the program's nearly 150 participants that it far exceeds the amount of securities that the Federal Reserve holds. Consequently, the current absolute limit is ineffective, McAndrews said.

A growth limit would allow participants to increase their investments in the reverse-repo facility, supporting financial stability and monetary policy as intended, while disallowing outsized jumps in investments into it that could be destabilizing now. Such a cap could constrain inflows to the overnight reverse repo facility beyond some percentage relative to a prior base week or month, McAndrews said, also noting other options discussed in a 2015 Fed staff paper.

RUN RISK

Bank depositors are questioning the safety of their deposits following the sudden failures of Silicon Valley Bank, First Republic Bank and others, he said. But it is usual for bank deposits to be withdrawn whenever the Fed raises rates, as banks pay depositors far less than what they can earn at money market mutual funds. (See: MNI INTERVIEW: Deposits To Continue To Leave US Banks-Schnabl)

What's different is the Fed's overnight reverse-repurchase agreement (ON RRP) facility, launched in 2014, which allows select money market mutual funds, broker-dealers and government-sponsored agencies to place funds directly with the Fed overnight and, in exchange, to receive Treasury securities as collateral. With a rate of 5.05%, far above the 0.07% rate the average depositor earns on interest checking accounts, the facility has grown from about USD1 trillion in mid-2021 to around USD2.2 trillion recently.

"It wasn't unforeseen that it would be large, that it would be by and large stabilizing to the financial economy, and that it would support monetary policy implementation," McAndrews said, noting the facility helped preclude runs that might otherwise have occurred during the more recent financial storm.

Fed officials have said the ON RRP facility continues to support effective policy implementation and control over the federal funds rate, providing a strong floor for money market rates.

"I'm not advocating a change in the spread between the interest on reserve balances and the overnight RRP rate," McAndrew said, addressing some recent proposals, because the reverse repo rate helps to support and implement monetary policy appropriately and lowering the rate would essentially be a rate cut.

RESPONSIBLE CAPS

But the fear of a run into the reverse-repo facility is itself a risk, McAndrews said. "If people hold that belief, it would be rational for them to protect themselves from that risk by preemptively withdrawing deposits from banks and that's the concern. Banks could be harmed by the very presence of this concern."

This is crucial during the current period of bank failures and the federal debt ceiling uncertainty, said McAndrews who served for 28 years in the Fed system. As a result, at present the reverse-repo facility confounds the Fed's efforts to bolster the safety of the banking system, he said.