A standing repo facility might have helped the Federal Reserve head off unexpected money market turbulence as it shrank its balance sheet going into 2019, the authors of a new Kansas City Fed paper told MNI, renewing arguments for adding such a tool down the line.
A. Lee Smith of the Kansas City Fed and Victor J. Valcarcel of the University of Texas at Dallas said in an interview Friday that the drain on market liquidity as the Fed unwound its post-financial crisis balance sheet was almost twice as strong as the expansionary liquidity effects of QE, causing financial conditions to tighten and funding pressures to ripple into money markets and further to Treasury, corporate bond and foreign exchange markets.
"Quantitative tightening or normalization does not look like quantitative easing in reverse. It appears to transmit in a fundamentally different way," said Smith. While the central bank's balance sheet normalization process began in 2014, financial conditions did not begin to tighten significantly until the Fed reduced reserves in the banking system from 2017 to 2019, they found.
The lack of a tool to alleviate upward pressure on short-term interest rates as reserve balances declined effectively amplified the pass-through effect from rates to other asset markets, the authors said late last week.
LIMITING PRESSURE
"There is no natural upper bound on rates like there is [on the lower bound] for zero, and moreover the Fed did not employ any tools, such as a repo facility," Smith said. "They did not employ that to limit upward pressure on the funds rate, so we do see a much larger degree of pass-through from reserves to short-term interest rates."
The standing repo tool, which would allow qualified dealers to exchange Treasuries for bank reserves on demand, has been a subject of discussion at the FOMC for months. Dealers and some Fed officials first raised the idea in early 2019 as the central bank was revising its monetary policy implementation framework, but a number of questions over how the tool would work in practice slowed the policy debate.
Amid the coronavirus market turmoil that forced the Fed to vastly expand the scope of its open market operations, proponents have also highlighted its potential role as an automatic market stabilizer among other proposals for money market reform.
ASYMMETRICAL EFFECTS
While a repo facility could be helpful in unforeseen crises, the paper by Smith and Vacarcel show that it could also be advantageous as a guard rail at the upper end of the Fed's interest rate range -- to avoid an unwanted tightening of financial conditions when the Fed unwinds its balance sheet after the pandemic.
A core source of the asymmetries between Fed balance sheet expansion and normalization, the authors of the paper said, originates in the market for bank reserves and can largely be attributed to the central bank's toolkit for managing short-term interest rates.
"There is a much larger negative relationship between the spread in the fed funds rate and IOR and the level of reserves. That suggests that the liquidity effect is very salient during the normalization period relative to QE," Valcarcel said.
"Certainly tools you would deploy such as a standing repo facility would limit that pass-through from reserve reductions to interest rates," Smith said. "It would limit in our minds some of the tightening you would see during such an episode."
The likelihood of the Fed's adopting a standing facility depends on how fast policy makers may want to unwind financial market easing. The Fed could unwind its balance sheet while attempting to avoid tighter financial conditions, and then the case for a standing repo facility "could be made," Smith said.
